Understanding U.S. Bonds, Bills and Notes
When a government or corporation needs to raise money, they have the option of issuing bonds. As the need for flexibility has increased over the years, so has the variety of securities found in the marketplace. They can vary in length of issue, payment terms, tax implications, as well as risk.
In this article, we'll be discussing the various types of bonds issued by the United States government. That discussion will include Bills, Notes, Bonds, Inflation-Protected Securities, as well as Savings Bonds issued by the Treasury Department. As part of that discussion, we will talk about the maturities of these securities, their features, and the process for obtaining these bonds.
Issuers of Bonds
Generally, bonds are issued by two entities: governments as well as corporations. Within the former category there are federal, state, and local governments. Corporate bonds offer investors greater returns, but carry a higher risk of default. Government bonds offer investors lower returns, lower risk of default, and often provide the benefit of tax-free returns.
Also referred to as U.S. Government bonds, these are securities issued by the U.S. Department of the Treasury. The investment opportunities offered by the federal government include: bills, notes, bonds, as well as inflation-protected securities.
Also known as T-bills, these are short term government securities that mature in as little as a few days to as long as one year. Treasury bills are sold at a discount to their face value. For example, if a Treasury bill with a par value of $1,000 sells for $950, the owner will be paid $1,000 when the security matures. The purchasing process involves placing either a competitive or noncompetitive bid on the bill (discussed later). Treasury bills are sold in increments of $100, with a minimum purchase of $100.
Also known as T-notes, these bonds earn a fixed rate of interest, which is paid every six months. In addition to receiving interest payments, the holder will receive the par value of the note at maturity. Treasury notes are sold with terms of 2, 3, 5, 7, and ten years. T-notes can be purchased through TreasuryDirect, a broker, or a banker. The purchasing process involves placing either a competitive or noncompetitive bid on the note. T-notes are sold in increments of $100, with a minimum purchase of $100.
As was the case with T-notes, Treasury Bonds pay a fixed rate of interest every six months. They also pay the bondholder its face value at maturity. Treasury Bonds are issued with a 30-year term. The price and yield is determined through an auction process. Noncompetitive bids can be placed through TreasuryDirect, while competitive bids require the use of a banker or broker. Treasury Bonds are sold in increments of $100, with a minimum purchase of $100.
Treasury Inflation-Protected Securities
Also referred to as TIPS, Treasury Inflation-Protected Securities provide holders of these investments with protection against inflation. TIPS pay a fixed rate of interest every six months. They also pay the bondholder its face value at maturity. TIPS are issued with terms of 5, 10, and 30 years. They offer protection against inflation by adjusting principal with changes in inflation. As inflation increases, the principal on TIPS will increase. A decrease in the rate of inflation results in a decrease in the TIPS principal value.
The measure of inflation used by these securities is the Consumer Price Index. The principal on Treasury Inflation-Protected Securities is adjusted every six months. Since the rate of interest is fixed, and based on the principal of the security, it takes six months for the next interest payment to adjust to the new principal value.
The price paid for TIPS is determined through an auction process. Noncompetitive bids can be placed through TreasuryDirect, while competitive bids require the use of a banker or broker. TIPS are sold in increments of $100, with a minimum purchase of $100.
I Savings Bonds
At one time, I Savings Bonds were only available as a paper investment; these bonds are now available in electronic form too. It's also possible to convert Series E and EE paper bonds to electronic form. Like the TIPS mentioned above, the interest rate on these securities adjust with inflation. I Savings Bonds will be assigned an annual interest rate, which reflects a fixed rate of interest plus an adder for a semiannual measure of inflation.
I Savings Bonds pay interest when redeemed. To receive interest payments, they must be held a minimum of one year and a maximum of 30 years. Redemption before a five-year term results in the forfeiting of three months of interest. I Savings Bonds are sold at face value, and the electronic version can be purchased in denominations of $50, $75, $100, $200, $500, $1,000, and $5,000. In addition, paper securities can be purchased for as little as $25. Individuals are limited to a maximum of $5,000 in any calendar year.
EE Savings Bonds and E Savings Bonds
E Savings Bonds have now been replaced with EE Savings Bonds. The features, denominations, and rules that apply to Series EE are exactly the same as those described above for the I Savings Bond, with one very important difference. Unlike I Savings Bonds, Series EE pay a fixed rate of interest, which is known when purchased. These securities are not indexed for inflation.
Electronic versions of EE Savings Bonds may be purchased through TreasuryDirect, while paper versions of these securities can be purchased through financial institutions or through the mail by filling out a form on TreasuryDirect.
Competitive and Non Competitive Bids Explained
As mentioned above, Treasury Bills, Notes, Bonds, and Inflation-Protected Securities are purchased through an auction process. That auction accepts two types of bids: competitive and noncompetitive.
All competitive bids must be placed through a broker or bank. When placing this type of bid, the investor is specifying the yield they are willing to accept for a given security. There are three possible outcomes from the auction:
- Accepted in Full: if the yield bid is less than the yield determined during the auction, the investor will receive the full value of the bonds they wanted to purchase.
- Partial Acceptance: if the yield bid is equal to the yield determined during the auction, the investor may only receive a portion of the bonds they wanted to purchase.
- Rejected in Full: if the yield bid is higher than the yield determined during the auction, the investor will not receive any of the bonds they wanted to purchase.
When placing a noncompetitive bid, the investor is agreeing to accept the interest rate yield determined during the auction. As such, they are guaranteed to receive the full amount of the bonds they wish to purchase. Noncompetitive bids can be placed using a broker, bank, or TreasuryDirect.
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