Monday, August 21, 2006

Treasury Bonds, Notes and Bills Explained

Bonds, in general, are nothing more than a means by which businesses and governments borrow large sums of money. Since the sums desired are usually more than a single bank or large investor is willing to loan, the company or government issuing the bond divides the total they need into $1,000 units and sells the units individually. This allows a large number of investors and banks to participate in the loan without assuming the risk of taking the entire loan. Purchasers of the bonds can further limit their risk and commitment by reselling some or all of the bonds they purchased to others without having to wait until the bond reaches maturity.

Like any loan, the principal or amount borrowed is the face (also called "par") value of the bond. Since bonds are usually issued in units of $1,000, the par value of most bonds is $1,000 and this is the amount the issuer must repay to the bond holder (the purchaser of the bond) at maturity. Bonds pay interest and the interest rate the issuer pays is the agreed upon interest rate times the par value. The maturity date is the date on which the issuer must repay the bond holder the face value of the bond and thereby cancel the debt. Some bonds have a "call" feature which allows the issuer, at their option, to repay the bonds early. The issuer is not required to repay early but can repay early if they so desire. If there is no call feature then the issuer cannot force the bondholders to accept early repayment. The existence or non-existence of a call feature can be an important consideration in some cases when deciding to purchase a bond. Assume an investor has a need for a fixed stream of income for a period of, say 15 years, and purchases bonds with a maturity date of 15 years in the future and paying an interest rate that will generate the desired income stream. If the bonds have a call feature and the issuer exercises their right to call the bonds after 5 years, the investor's plan for fifteen years of income will fail and the investor will be forced to devise another means of generating the needed income stream.

In the United States a "Treasury Bond" is a debt instrument which is sold to investors by the U.S. Treasury. The main difference between a Treasury Bond, a Treasury Note and a Treasury Bill (T-Bill) is mainly the length of the term. "Treasury Bonds" have maturity dates greater than ten years, while "Treasury Notes" have maturity dates ranging from two to ten years and "Treasury Bills" have maturity dates ranging from a few days up to 26 weeks. All three of these are issued in $1,000 units and all three can be purchased by individuals as well as banks and other institutional investors. Bonds and Notes are issued by the U.S. Treasury to finance its long term debt and these are what make up the "national debt". Treasury Bills, on the other hand, are what the Treasury uses to manage its day to day cash flow and the sum of these T-Bills is what makes up the "deficit" that politicians and pundits always claim to be concerned about. Government revenues, like individuals' incomes, do not always match their bills and the Treasury is often forced to borrow when expenses exceed revenue the same as an individual pulls out their Visa when the car breaks down and the repair cost is more than they have in their checking account. And, just as individuals whose credit card debt gets too large, either consolidates it into a more manageable payment with an intermediate term consolidation loan or longer term loan by refinancing their home, the Treasury does the same when the T-Bills pile up and it consolidates them with intermediate term notes or long term bonds.

The other nice feature about any bond (and this includes Treasury Notes and T-Bills as well as Treasury Bonds) is that individual purchasers do not have to keep the bond to maturity to get their money back. Holders of bonds can sell them to others who can either hold them to maturity or sell them again before maturity. The $1,000 units makes this easy. However, when bondholders sell bonds before maturity they usually will not receive the $1,000 face value of the bonds. This is because, for most bonds, the interest rate is fixed at the time the bond was issued. A $1,000 bond with a rate of 10% will pay $100 per year in interest ($1,000 x 10%) until maturity. However, if market interest rates fall to 5%, the price of the bond being re-sold will rise to $2,000 so that the $100 per year that the issuer will continue to pay is now equal to 5% (5% x $2,000 = $100) of the price the new purchaser paid for the bond. Of course, if the new owner holds the bond to maturity they will only receive the $1,000 face value of the bond. Bonds that sell for more than their face, or par, are said to be selling "above par". On the other hand, if interest rates rise to 20%, the price of the bond will fall so that the $100 annual interest on the bond calculates to 20% of what the new buyer paid. In this case the bond will sell for $500 (20% x $500 = $100). If the new buyer holds the bond to maturity that holder will receive the $1,000 face value of the bond. Bonds selling for less than their face, or par, value are said to be selling "below par".

Investing in bonds, whether Treasury Bonds or bonds of corporations or other nations can be more complex than I have explained here. Here I have tried to explain the basic terms and concepts which you can then build upon depending upon your investment needs and objectives.