U.S. Government Obligations

There are a number of different kinds of marketable U.S. government securities, including Treasury bills, notes, and bonds.

TREASURY BILLS. Treasury bills are sold at a discount (less than the face value) and mature at face value. They mature at different periods, usually 13, 26, and 52 weeks. Bills are considered highly liquid, secure, short-term investments.

TREASURY NOTES. Treasury notes have maturities ranging from 1 year to 10 years. They are sold at or near their face value and pay their interest on a semiannual basis.

TREASURY BONDS. Treasury bonds also pay their interest on a semiannual basis and are sold at or near their par values. However, T-bonds have maturities that are greater than 10 years, going all the way up to 30 years. Generally, analysts use the 10-year and 30-year yields as benchmarks when discussing the economy and interest rates. Like T-bills and T-notes, Treasury bonds are highly secure investments.

Treasury bills aren’t callable, due to their short-term maturities. Treasury notes are also not callable. However, Treasury bonds may be. Some longer-term bonds may be callable at par five years before they mature. Otherwise, they aren’t callable. The fact that generally these securities aren’t callable, coupled with their high credit rating, makes Treasury bills, notes, and bonds an important part of some investors’ portfolios.

Generally, the interest and capital gains on Treasury notes and bonds is fully taxable for federal income tax purposes, but exempt from state and local income taxes. This somewhat increases the aftertax yield when compared with equivalent yields from corporate bonds or other interest-yielding accounts. If Treasury notes or bonds are purchased at a premium, the premium amount may be amortized over the remaining life of the bond, just as it can in the case of corporate bonds. The sale of Treasury notes and bonds also brings about the same result as corporate bonds when it comes to paying federal income tax.

INFLATION-INDEXED TREASURY NOTES AND BONDS. The U.S. Treasury has introduced Treasury Inflation-Protection securities. These are T-notes and bonds that have a fixed interest rate, which is applied to the principal amount that is adjusted for inflation or deflation periodically. The inflation or deflation amount is based on the adjusted consumer price index. These securities pay interest semiannually, just like regular T-notes and bonds, and the principal is paid upon maturity. This principal includes any inflation or deflation adjustments that have been made over the life of the security. At maturity, the greater amount of either the original par value or the inflationadjusted principal will be paid. Therefore, if serious deflation occurs and at maturity your note or bond is not worth the original par value, you will receive the greater amount, in this case, the original par value. These notes and bonds are designed to protect investors from any inflation risk.

Because the principal amount and the interest paid on these are subject to adjustments, there are tax consequences. Each year, the investor will have gross income from not only the interest amount paid, but also the amount that the principal has been adjusted by, if the principal is increased for inflation. If the principal were decreased for inflation, the taxable amount would decrease. Even though the principal isn’t paid until the bond or note matures, current tax law stipulates that the adjustments be taxable for the year in which they occur. Because of this, many advisors believe that these inflation-adjusted securities may be best for tax-qualified plans, such as IRAs, since the annual income isn’t taxed until distributions begin.

For example, the Smiths decide to purchase a 10-year inflationindexed Treasury note with the face value of $10,000. Its current coupon rate is four percent. Let’s assume that for the year following the Smith’s purchase, inflation is 3.5 percent. At the end of that year, the note’s principal amount would be adjusted to $10,350; the interest paid to the Smiths would be based on this new amount, or $414 per year. The principal amount will continue to be adjusted like this for the lifetime of the note. Thus, the corresponding interest rate will also adjust to the new principal amount each year.

Face  value = $10,000 - Interest = 4%  - Inflation = 3.5%
   New  face value = $10,000 + 3.5% = $10,350
   New  interest rate = $10,350 - 4% = $414  (paid annually)
   All  amounts are hypothetical.