Understanding The Different Types Of Government Bonds
If you're in the market for an investment in bonds, you may find the number of options a bit bewildering. For example, there are corporate bonds; there are bonds available from agencies that are associated, or partially associated, with the federal government. There are state and local bonds. And then there are treasury bonds.
When it comes to buying bonds as a way to invest, conventional wisdom tells the investor that U.S. government bonds are a pretty safe bet. Unlike bonds issued by private entities which can teeter into bankruptcy, the federally issued bond is backed by the Treasury Department.
But what kinds of U.S. Government bonds can an investor choose? We examine them and break out the most pertinent details of the various treasury bond types, how they work, and what you need to know if you choose to put your money into one -- or several.
Also known as securities, U.S. Treasury bonds come in the following types:
Purchased in $1,000 to $1 million amounts, treasury bonds mature over a 30-year term (maturity is the point at which you collect back your principal payment plus final interest). The interest rate on the bond pays out every six months. These are often used to finance education and retirement savings. You can buy these from Treasury Direct (a service of the U.S. government).
If you're looking for a range of maturity term lengths, the treasury note supplies some options. Available in 2-, 3-, 5-, 7-, and 10-year versions, you can buy them in $1,000 denominations. Like a treasury bond, a treasury note pays interest every six months, but the interest rate of your bond varies at the point of purchase. You can buy treasury notes through a bank or a broker, or via the Treasury's auction process. When you buy these at auction you either accept whatever rate the seller sets (this is called anon-competitive bid), or you request an interest rate and hope to get it (this is known as competitive bid). The non-competitive bid is an assured sale, but the competitive version is not. That is, you might not get the rate you want, and so the purchase won't go through. Buyers tend to use notes for education and retirement purposes.
Treasury Inflation-Protected Securities
Another option, when it comes to flexible maturity periods, is the TIPS. Selected at 5-, 10-, and 30-year terms, they come in $1,000 denominations. They can be bought by competitive or non-competitive bids at bank or broker auctions, or from Treasury Direct. After purchase, the interest rate on TIPS fluctuates based on the Consumer Price Index. That means that inflation and deflation drive the rate up and down. If the economy is inflationary, your interest is going to be higher when the bond pays out every six months. However, if deflation is a factor, your rate may drop. At the point of maturity, you collect either the principal as it is adjusted under these factors, or you collect the original amount you paid -- whichever amount is greater. These are a common choice when supplementing retirement savings.
A shorter term investment than most of the securities listed above, treasury bills mature for just a few weeks up to a year. In a sense, you buy low and collect slightly higher. Purchase a T-bill for (say) $590 and you could collect something in the order of $600 when it matures. You buy these through banks, brokers, at auction -- in a competitive or non-competitive bidding process like that of TIPS -- or from Treasury Direct.
These come in two types: Series EE and Series I. An EE bond is bought for $25–$5,000 and can be redeemed after 12 months. You pay a 3% penalty if you cash out early, however. Interest pays out at the end, based on a fixed rate. The government guarantees full face value after 17 years, but you can keep accruing interest for up to 30 years, if you so desire. Series I bonds work in much the same way, but the interest rate is partly determined by inflation (like a TIPS). You can buy both kinds of savings bonds from most banks, from Treasury Direct, and, in the case of Series I, even via your federal income tax refund. Savings bonds are often purchased as gifts, or to supplement education and retirement. Note that, unlike other kinds of treasury securities, savings bonds cannot be resold by the purchaser.
Whichever bond you choose, remember to factor in taxes when considering the overall return. Remember that all treasury securities are exempt from state and municipal taxes. Note, however, that federal income tax will be assessed every time the interest pays out on a treasury bond, including at the point of maturity.