By Gary Meeks, RICP®
Interest rates on safe investments have been at a historical low for some time, but in recent months, that has changed dramatically. The federal reserve has raised rates several times to combat inflation. Even more rate hikes could be on the way.
U.S. treasury securities are a direct obligation of the U.S. government and therefore essentially carry no risk. Generally, there are three categories of U.S. treasury securities: bills, notes and bonds. The main difference is the length of time to maturity. Since they are a debt security, you are essentially lending money to the U.S. government. The U.S. government promises to pay back your principle at maturity and a stated rate of interest.
Treasury Bills are 0-1 years. Treasury bills do not pay periodic interest, but pay all interest at maturity. Treasury securities come in units of $1,000 per bill/note/bond. Treasury bills are discounted from the $1,000 face value. At maturity, investors receive $1,000 per unit. Example: you pay $950 per unit. At maturity, you receive $1,000 per unit. Your interest is $50 per unit or approximately 5.26%. ($50/$950 = 5.26%)
Treasury Notes are 2-10 years and Treasury Bonds are 20-30 years. Both notes and bonds pay interest semiannually. Because treasury security holders can sell their investment any time on the open market, you can find virtually any maturity that you might be interested in, but not more than 30 years.
STRIPS: STRIPS are treasury bonds that have had the coupons (interest payments) stripped away. Like bills, they don’t pay interest or coupons periodically and can be purchased for most any timeframe from a few days to 30 years. All interest on STRIPS is paid at maturity and like bills are sold at a discount from the $1,000 face value. STRIPS provides an alternative to traditional bonds for investors who need to rely on definite amounts of money coming due at a specific future date. Although they post negative cash flows until maturity, they may also provide superior yields to traditional bonds in some cases and will always mature at face value ($1,000 per bond).
Potential Risks: If you cash in your bills, notes or bonds prior to maturity, you could lose principal. If you hold them to maturity, you will receive your principal back. The interest you receive along the way is also guaranteed to be paid by the U.S. government.
You may wonder how you could lose money if you cash in your securities early. If you sell early, you must put your bill, note or bond up for sale on the open market. You will receive the market value at the time of the sale. Changes in interest rates affect the value of your securities. Generally, if interest rates have increased since you purchased your treasury security, a buyer will not be willing to pay full price for your security, so in order to have it sold, you will have to offer it at a discount.
Treasury securities come in units of $1,000 per bill/note/bond. In this example, you will have to sell your security for less than the face value, which is $1,000 per unit. The opposite is also true; if interest rates have declined since your purchase, you would be able to sell your security at a premium or more than $1,000 per unit. In such a case, you could end up making a higher return on your investment than the initial stated interest rate.
How Are Treasury Securities Taxed? You will have to pay federal income tax on the interest you earn on these securities, but you will not have to pay state taxes. This could be a real advantage when compared to CDs, since interest on CDs is federal and state taxable. Utah’s state tax rate is 4.85%. Some states have much higher tax rates, making treasury securities even more attractive. For example, in California, state tax rates go as high as 12.3%.
There is a simple formula to compare CD rates to treasury rates. Let’s say you could get 5% on a two-year treasury; divide 5% by the reciprocal of your state tax rate. Example: in Utah, the state tax rate is 4.85%, so 1 minus .0485 equals .9515. You then take your treasury rate and divide by .9515, the formula looks like this .05/.9515 = 5.25%. This means your CD rate would need to pay 5.25% to be equal to a treasury security paying 5%.
To summarize, treasury securities have the following characteristics: they are a direct obligation of the U.S. government, so interest is guaranteed to be paid, and if the securities are held to maturity, your principal is protected. Selling your treasury security prior to maturity could result in loss of principal. Depending on the maturity of your treasury security, you may receive all interest at maturity or payments periodically, such as semiannually. Treasuries are state income tax free. If you sell a treasury security prior to maturity, you could lose principal. Treasuries are available as bills, notes, bonds or STRIPS, as noted above. If you’re looking for safe investments with guaranteed rates, you may want to consider treasury securities or certificates of deposit. Interest rates have increased dramatically in recent months.
Gary D. Meeks, RICP®, is a registered representative offering securities and advisory services through Cetera Advisor Networks LLC, member FINRA/SIPC, a broker dealer and Registered Investment Adviser. Cetera is under separate ownership from any other named entity. 90 West 100 North STE 6, Price, UT 84501 (435) 637-8160.
“The views stated in this letter are not necessarily the opinion of Cetera Advisor Networks LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.”