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Posted on 23 December 2013.
Treasury bonds (tbonds) are marketable, fixed interest securities issued by the federal government. Tbonds have a maturity of greater than 10 years, and are sold in increments of $1,000. Interest payments are made semiannually and income is only taxed at the federal level. Tbonds and other treasury securities are considered risk free by investors. So if treasury securities are supposed to be risk free, then how could it possibly be time to be short on treasury securities? Read on…
In this post I will show you how interest rates and inflation can affect the price of treasury securities. While treasury bonds may never default and be free of credit risk, they can end up costing you a fortune if you don’t understand how these securities work. To start off I will explain what each treasury security is. After you understand what the investment is we can then begin to learn how interest rates and inflation rates affect the price of treasury securities, and ultimately how there could be a ton of risk moving forward by owning them.
Notes – Treasury Notes are similar to Treasury Bonds. The main difference is they have a maturity between 1 and 10 years. Usually, the interest rate of treasury note is a little bit less than a treasury bond due to a faster maturity.
Bills – Treasury Bills have a maturity of less than 1 year. TBills pay less interest than TNotes and TBonds due to a much shorter time until maturity. A shorter maturity time leaves the investor much less susceptible to a price risk of treasury securities. TBills are issued through a competitive bidding process. Investors purchase these securities at a discount to par, and instead of getting fixed interest payments investors are returned the par value at the maturity of the bond.
For this example, lets say a TBill is priced at $970 with a par value of $1,000 when it matures in 6 months. To calculate the interest rate you take the $1,000 and subtract $970 which equals $30 (1000970=30). Next, divide $30 by the price of $970 which equals 3.09% (30/970=.0309). If you purchased this security your would earn a 3.09% interest over the 6 month span.
Treasury securities are considered to be free of default risk. This means the interest rate is simply the rate of return required by the investor to cover inflation plus a small percentage of income required for letting the government borrow your money.
Inflation is a Treasury Security’s worst enemy. If inflation rate increases the interest rate will need to increase as well to compensate the investor for the additional cost of living. If you are having trouble understanding this concept think of it this way: You don’t invest to lose money over time to inflation. If the interest rate of a bond did not cover the inflation rate then the investor would be slowly losing money over time instead of increasing their wealth.
The central bank of the United States sets the interest rate or borrowing rate for the entire county. The Federal Open Market Committee (FOMC) is responsible for setting interest rates. If you have been following the FOMC Minutes you already know that longterm interest rates are at historically low levels. Right now the FED has set the national interest rate at 2.0%.
The FOMC sets interest rates according to its expectations of future inflation. Historically, shortterm interest rates, such as LIBOR have been highly correlated with the federal funds rate. The FED sets these rates to promote economic growth while maintaining price stability.
To understand why inflation and interest rates affect the prices of bonds you first need to understand the concept of yield and price. For the purposes of this article I will use the most popular calculation YTM (Yield To Maturity). Bonds can be priced at a premium, discount or par value. If a bond is priced at a premium then it will sell higher than its par value because the interest rate is more favorable than current market interest rates. A bond that is selling at a discount has an interest rate that is less favorable than current interest rates. Finally, a bond selling at par has interest rates that are equal to current market interest rates.
Calculating a bond’s price is relatively easy. The price of a bond is the present value of its interest payments plus the par value of the bond when it matures. The equation to calculate the price of a bond looks like this:
For more information on how to calculate the price of a bond visit this article on advanced bond pricing by investopedia. For the purposes of this post what you need to understand about yield is that when the interest rate of a bond is higher than current market rates then the price of the bond increases (worth more than par value). When the interest rate of the bond is less than current market rates then the price of the bond goes down (worth less then par value).
The longterm and shortterm interest rates set by the FED are the key to this discussion. Since we currently have historically low interest rates there’s really no place for interest to go except increase. On several occasions the FOMC has admitted they would like to restore the Federal Funds Rate to its level before the great recession. Many people believe that date is rapidly approaching. After the last few FOMC Minutes it was surprising that they have decided to push of increasing the Federal Interest Rates.
The FOMC will begin to increase the interest rates when it believes the economy is stable and has fully recovered from the great recession. When they increase this rate many longterm Treasury Note and Treasury Bond holders can be in for some big trouble, because hiking the federal interest rates means the FOMC expects there will be higher inflation. For holder of Treasury Notes and Treasury bonds this could create a disaster.
As we learned above when the interest rate of a bond is below the federal interest rates then the price of the bond will fall so that new buyers of the bond can get the same effective interest rate as current market rates. By paying less than $1,000 dollars for the bond they will effectively achieve a higher interest rate because the par value is no longer $1,000 (for this example lets say the new price is $800). If the interest payments or coupons are $15 every six months then that is a 3.0% annual interest rate (30/1000=3.0%). If we change the price to $800 then the new interest rate is 3.75% (30/800=3.75%).
Since the FED has openly stated their mission is to increase interest rates once they see that the economy has stabilized we already know their intentions are to raise the rates. With this in mind it may be time to consider being short on treasury securities. if you own Notes or Bonds, but still want to be in a risk free investment you may want to consider Tbills. Tbills have much shorter time to maturity so the an investor in these securities will not be locked into a low interest rate for a long period of time. When investing in treasury securities you never want to be earning less than inflation. If you are in a low interest rate longterm treasury security it might be time to get rid of those so you don’t get stuck with a bad investment or have to sell the bonds at a significantly discounted price.


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