Investing In Bonds

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One of the most popular and safest investment vehicles in the world are U.S. treasury securities. These securities are basically an I.O.U from your Uncle Sam, for which the government will pay you interest for lending money to the U.S. government. The reason why they are considered the safest investment vehicle in the world is because they are. This is not a matter of opinion though some might argue that it will be. The United States has never failed to honor its obligations on outstanding debt, ever, and because of that U.S. treasury securities are the highest rated investments in the world.  Recent budget issues surrounding the U.S. fiscal picture have prompted these securities to be downgraded by several rating agencies, but that is a topic for another article and despite the downgrade, U.S government paper is still the safest investment vehicle in the world. However, you should also bear in mind that you pay a price for that safety and a good rule of thumb to follow is that the greater the return expected on a particular investment, the greater the risk associated with that investment. And an even more important rule to consider is that even though bonds are safe you can still lose money investing in U.S. treasury bonds.

Various U.S. Treasury Securities

The reason why the title of this section is U.S. Treasury Securities and not U.S Treasury Bonds is because not all U.S securities are bonds, which is one of several key things to know before lending any of your money to Uncle Sam. The United States government, like most every government and major corporation in the world reaches out to the world financial markets to borrow money. Even if the government budget is in a surplus, yes there was a time, they will still go to the market to raise money for all of the many programs and projects that fall under the heading of government spending. The agency of the U.S. government that oversees the process of issuing Treasury securities is the Treasury Department, not the Federal Reserve bank. The Treasury will issue securities with various maturity dates from 30 days out to 30 years. Treasury bills are securities that mature in one year or less, Treasury notes are securities that mature in from 2 years out to 10 years, and Treasury bonds are those securities that mature in 15 to 30 years.

Understanding U.S. Treasury Securities

Treasury bills are issued at a discount and they really aren’t a viable investment vehicle for the average investor. For one thing, they mature in such a short period of time and the other is that these days the return is minimal if anything. T-notes and T-bonds are interest bearing securities, backed 100% by the full faith and credit of the United States government, which pay interest to the holders of these securities every six months. These are also investments that in and of themselves are generally within the realm of much larger investors that can afford to buy blocks of this paper when they are auctioned by the Treasury. These investors are usually large corporations, pension funds, sovereign governments, and other such entities. The individual investor can also purchase U.S. treasury paper, but the most common way to invest in these vehicles is through a bond fund offered by a bank or investment banking firm.

What Will I Earn Investing In U.S. Treasury Securities?

It is very important to understand that the yield, or your return on your investment on Treasury notes and bonds is not necessarily the interest rate that is attached to the particular note or bond you own. Confused? Well, you aren’t alone and that is why is is usually best for small and medium investors to invest in a bond fund rather than thinking about purchasing these instruments when they are auctioned. ┬áBonds and bond funds are sold based on current interest rates, which are dictated by supply and demand in the market and change 24/7 without fail. To illustrate the difference between your rate of return versus the coupon, or rate of interest on the security, think about it this way. The treasury issues a 10 year bond on day 1 with an interest rate attached to it at 5%, meaning that anyone that purchases that note the second it is issued, and who holds it for its full maturity of 10 years, will earn 5% on their investment. Now it’s one month later and the person who owns that T-note wants to sell it to you. However, during the course of the month interest rates have declined to 4%, meaning that he or she only has to offer you a 4% return because that is where the market is today for 10 year T-bonds. You will have to pay a premium for this piece of paper, meaning that instead of say $100 you will have to pay $110 for that note. On the other hand, if rates go higher, you will be able to buy that 5% coupon T-note at a discount, say $90 versus $100. You see, I told you it was confusing.

The Bottom Line

Bonds are generally safe investments and you can find out the rating for bonds being issued by any country or corporation from one of the many rating agencies. And before investing in anything but U.S. treasury securities you should do so. However, even U.S. Treasury bonds are risky if you don’t plan on holding them until they mature, especially if you buy into a bond fund when interest rates are low and rising. In fact, you risk losing a significant portion of your principal investment if you buy into bonds and then try to sell them after interest rates have moved higher. As with all other investments, do extensive homework before buying bonds or into a bond fund.

My take:

Bond yields are quite low and its hard to imagine that they will drop any further. This presents significant risks for anyone thinking about investing in bonds right now. For those savvy investors that were smart enough to be in bonds during this historical time in U.S. interest rates, congrats and perhaps you should think about taking some profits. For the rest of us, steer clear for a while because if you buy now and interest rates start moving in the only direction left to go, up, your investment portfolio will be in trouble.

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