The U.S. government can raise money through taxes or by issuing bonds. Unlike any other debt instrument, U.S. Treasury bonds are considered free of credit risk because they are backed by the full faith and credit of the United States government.
Because Treasuries aren't affected by credit risk, changes in their price and yield are largely due to fluctuations in the interest rate, consumer demand, and economic and political events. Treasuries are considered safe investments, and investors tend to sell off their riskier investments and buy Treasuries when the market becomes volatile. This flight to quality leads to rising Treasury bond prices and falling yields.
The Treasury issues a variety of securities that differ in terms of maturity and how, or if, coupons are paid. Interest income is always subject to federal income tax but is exempt from state and local income taxes.
Treasury bills, or T-bills, have the shortest terms, with maturities of four, 13 or 26 weeks. T-bills do not make interest payments, but are sold at a discount, which is determined at the time the bill is auctioned to the public, and redeemed at par. For example, if you pay $960 for a T-bill, you will receive $1,000 at its maturity. The $40 represents your interest.
Treasury notes, or T-notes, have slightly longer maturities of two, five or 10 years and pay interest semiannually at a fixed rate. Changing yields and prices of the 10-year note are tracked as a benchmark for bond performance in the financial press. Low yields indicate that more consumers are investing in the bond market, which drives bond prices up. High yields signify that more consumers are investing elsewhere, as decreasing demand leads to lower bond prices.
Treasury bonds, or T-bonds, have maturities of 30 years and pay interest twice per year. Prior to 2001, T-bonds were issued with maturities ranging anywhere from 10 to 30 years. In 2001, the Treasury stopped issuing T-bonds entirely, though older bonds still traded on the secondary market. It resumed issuing 30-year bonds in 2006.
The Treasury helps investors curb the effects of inflation through Treasury Inflation-Protected Securities (TIPS). These bonds have maturities of five, 10 and 20 years and have semiannual fixed-rate payments based on principal that's adjusted for inflation twice a year according to changes in the Consumer Price Index (CPI). During inflationary times, the index will rise and principal will be adjusted upwards. In deflationary times when the price index goes down, the principal will be adjusted downward accordingly. As protection from deflation, investors are paid the greater of the inflation adjusted or original principal at maturity.
Like Treasury bills, STRIPS are zero-coupon bonds that are sold at a discount and redeemed at par. An acronym for Separate Trading of Registered Interest and Principal of Securities, STRIPS are the creation of broker-dealers. Broker-dealers make them by separating their Treasury holding into interest and principal payments streams which are repackaged as securities before being sold. STRIPS are more susceptible to interest rate risk than unstripped Treasuries, and prices may vary widely. In addition, unless you hold STRIPS in a tax-deferred account, you will owe income tax each year, as if you were receiving regular interest payments.
Unlike other Treasuries, savings bonds are nontransferable, which means they cannot be sold in the secondary market. Series EE savings bonds receive regular fixed interest payments and can be bought electronically or as paper certificates. Electronic EE savings bonds are guaranteed to double in value at 20 years and pay interest for 30 years, while paper EE bonds are purchased at half face value, and are redeemed at maturity for full face value. For example, if you purchase a paper EE savings bond for $50, you will receive $100 upon maturity. Series I bonds are also 30-year investments that make semi-annual interest payments that are adjusted for inflation.
You can also buy Treasuries by using leverage, or borrowing money from a brokerage firm to pay for the securities. Though this is riskier, there is the potential for greater returns. Bond interest rates are either based on a broker loan rate, which is paid by stock investors buying on margin, or the repo rate, which are lower rates offered in the repo market. The repo market is an overnight loan market for financing Treasuries that's used primarily by institutions.