treasury

How Bond Prices and Yields Work

Tim Lemke — Wed, 04 Jul 2018 08:30:14 +0000

When we talk about investing, we frequently talk about stocks. Stocks are likely to make up a the bulk of your investment portfolio during the majority of your investing years.

Bonds, which tend to be less risky but also less rewarding, are more important as you get closer to retirement. However, bonds can be a helpful part of your investment mix at any age, and it's important to understand how they work — even if you don't own many of them right now.

Let's examine bonds and why we should pay close attention to them these days. (See also: 5 Crucial Things You Should Know About Bonds)

How government bonds work

A bond is simply a vehicle that governments and companies use to borrow money. People buy bonds, and in exchange, receive interest payments. Our country would barely be able to function without bonds.

For the sake of this discussion, let's focus on government bonds. The U.S. government floats many different securities, but the most common are the 30-year and 10-year Treasury bonds. These bonds pay interest every six months, and the principal of the bond — often referred to as "par value" — is paid in full after 30 or 10 years.

There are also popular securities called Treasury Inflation-Protected Securities (TIPS). The principal of a TIPS can go up or down depending on the movement of the Consumer Price Index.

U.S. Treasuries are very popular worldwide because they are backed by the full faith and credit of the U.S. government, which has historically always repaid its debts.

Yield and price

If you plan to hold onto a bond until it matures, you'll likely want to take a look at its yield, which is simply a calculation of how much money you'll make on the investment. So for example, let's say you have a $10,000 30-year bond with an annual interest rate of 5 percent. This would mean you'd get $500 per year. This is the bond's annual yield. It's also referred to as the "nominal" yield.

There's another factor that determines how much money you make from a bond, and that is price.

Let's say that the owner of the $10,000 bond above chooses to sell the bond before it matures, for $9,000 — maybe because the issuing company is struggling to stay afloat, or because interest rates are about to see a substantial rise. The buyer of the bond will still continue to get interest payments based on the face value of the bond ($10,000). These interest payments are fixed.

Thus, the buyer is receiving the same payments, but because the buyer paid less for the bond, the yield is 5.55 percent. ($500/$9,000=0.0555, or 5.55 percent).

When a bond is selling for more than its issue value, we often hear people say it is trading "at a premium." If it is selling at less than its issue value, it is selling "at a discount."

Generally speaking, people seek to find bonds selling at a discount, because they result in a higher yield.

Why prices rise and fall

The price of bonds is very closely impacted by interest rates. The prevailing interest rate — that is, the interest rate on bonds being issued at that particular time — can make any other bond seem more or less attractive to investors.

To illustrate this, let's say you hold a 30-year bond with a 5 percent interest rate, but rates have been rising and now average 6 percent. Because your bond now has an interest rate that is lower than the prevailing average, it's less attractive to investors. Thus, if you want to sell the bond, you may have to lower the price to ensure investors can get the same yield.

The opposite is also true. When interest rates are falling, any bond with a higher interest rate becomes more attractive and can demand a higher price.

Inflation is known to indirectly impact bond prices because it is accompanied by higher interest rates.

Bond prices are also indirectly impacted by the performance of the stock market. When the stock market is doing well, people tend to flock to stocks and their potential for higher returns, which in turn depresses demand and prices for bonds. But during times of economic distress, investors will often flock to the relative safety of bonds and this can cause prices to rise.

Why it matters now

Treasury yields have been on the rise in 2018, with the interest rate on a 30-year Treasury growing from about 2.8 percent at the start of the year to 3.1 percent as of the end of May. The yield on the 10-year Treasury is more than 2.9 percent, compared to 2.4 percent at the start of 2018.

There are many reasons why yields have increased, but generally they have to do with confidence in the economy and in the stock market. Treasury yields rise inversely to prices. Thus, a high yield suggests that demand for bonds is weak and that's depressing prices.

The trend is only expected to strengthen. The government is predicted to issue a lot of new bonds in 2018 as it looks to cover the cost of new tax cuts. Having more bonds in the market will lower demand for any individual bond, so prices will fall and yields will rise.

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This article is from Tim Lemke of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

4 Ways to Reduce Your Tax Bill With Bonds

Qiana Chavaia — Tue, 02 Feb 2016 22:00:06 +0000

Financial advisors recommend bonds to investors for portfolio diversification, as a fixed income investment strategy, and to hedge against inflation. Even better, some major bond classes can help you reduce your tax bill, too.

What's more, they are low-risk investments. Here's how you can reduce your tax bill with bonds. (See also: 9 Tax-Friendly Ways to Save Beyond Your Retirement Fund)

1. Invest in Municipal Bonds

Municipal bonds have long garnered the attention of high-earners seeking to minimize their tax obligations. Muni bonds are tax-exempt at the federal level and, in some cases, local and state tax exempt as well, especially if the investor resides in the issuing state or municipality.

Though munis faced some scrutiny during the financial crisis, many — if not most — munis deserve a second look now that local government finances are on much more stable footing.

2. Buy U.S. Treasury Bonds

U.S. Treasury bonds pay interest income once every six months. That income is exempt from state, local, and the alternative minimum tax. Some treasury bonds can also reduce your tax bill, even if investing outside of a retirement account.

3. Purchase Zero Coupon Bonds

Zero coupon bonds are exempt from state and local tax. As their name suggests, these government bonds pay no interest, but often offer higher yields. Investors beware, however: Zero coupon bonds come with higher risks than their traditional counterparts, so consider the risk-reward trade-offs before investing in this asset class.

4. Put Bonds Inside Tax-Free and Tax-Deferred Accounts

Investors can defer any taxes owed on interest income by delaying distributions and holding these investments in a tax-deferred retirement account, such as an IRA or 401K. Once the money is withdrawn at retirement age, it'll be taxed based on the individual's tax bracket. Using the same strategy, if they are kept in a tax-free account, such as a Roth IRA or Roth 401K, distributions taken at retirement are tax-free.

Are bonds in your portfolio?

This article is from Qiana Chavaia of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Stalemate on the Debt Ceiling?

Philip Brewer — Fri, 29 Apr 2011 10:00:14 +0000

The news is full of speculation about the result if there's a stalemate on the debt ceiling, but I know what would really happen. I live in Illinois.

You see, Illinois has been in much the same situation for years now. The legislature has appropriated more in spending than they raise in taxes, but there are sharp restrictions on how much money the state can borrow. (See also: Borrowers, Lenders, and Others — Beware Trusting the Government)

So what happened? Well, interest on our debt got paid. State employees' salaries got paid. State pensions got paid. Tax refunds got paid. Unemployment checks got paid. Direct benefits like food stamps got paid.

Who didn't get paid? Anyone who did business with the state. The state quit paying its bills. Business and contractors who provided services for the state got stiffed for months, and the state is by no means caught up on paying its bills (even though it recently raised taxes).

I'm confident that, if there's no increase in the debt limit for the federal government, the result would be much the same. There are a number of temporary measures the Treasury would take first — redeeming some debt owed to states, cities, and federal retirement funds — but once it exhausted those maneuvers, it would have to stop making some budgeted payments. But the Treasury would be deciding which payments to make and which to delay. The effect would be to give Treasury Secretary Geithner complete control over who gets paid when.

As I read it, there is only one constitutional requirement for federal payments — judges have to get paid. After that, if there's not enough money, the Treasury can pretty much pick and choose.

I'm sure the Treasury would pay the interest on the debt, because the public debt of the United States is what it cares about most. It'd also go ahead and roll over maturing debt (staying under the ceiling). It would go on paying military personnel and government employees. It would go on paying social security, railroad pensions, and other direct payments to individuals.

What the Treasury would quit doing, just like in Illinois, is paying contractors. It wouldn't refuse to pay them, it just wouldn't cut a check until the money came in. (It would rack up late-payment charges, but neither those nor the unpaid bills themselves count against the debt ceiling.)

In Illinois, where this went on for years, the government didn't just pay the bills in order. They gave priority to businesses that might fail if they didn't get paid. (Lots of businesses that contracted with the government to provide services to the poor had no non-government business. If they didn't get paid, they would be out of businesses in a matter of a weeks.) There was a whole procedure in place for businesses to make urgent claims for relief. If the situation went on at the Federal level for any length of time, I'm sure the same sort of thing would happen.

Think of the power this gives the Treasury! I'm sure they wouldn't do anything so crass as to pay companies that were donors to their party before paying companies that donated to the other party, but I wouldn't be surprised to see the power brought to bear only a little more subtly than that. For example, employers in a state where a senator was blocking a bill to raise the debt ceiling might have particular trouble getting their bills paid.

Personally, I don't think that situation would go on for very long. When the many large companies that do business with the United States quit getting paid, they'd have a quick chat with the Senators from every state where they have an office. When the many, many small businesses that have contracts with the federal government quit getting paid, they'd call up their Representatives and make it clear that they wanted the problem fixed. Most especially, once members of Congress realized that what they'd done was to hand the power of the purse over to the Treasury — give Timothy Geithner the power to decide who gets paid and who doesn't — they'd raise the debt ceiling and grab that power right back.

These insights brought to you thanks to my long experience living in Illinois.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Obama Eases Treasury Costs with At-Home Money Printing Stimulus

Paul Michael — Wed, 01 Apr 2009 20:57:57 +0000

Everyone is feeling the economic crunch these days, and that includes the Treasury department. It’s no news to anyone here that there has been increasing unhappiness with President Obama’s latest rounds of bailouts, but today could be a turning point for his recent negative PR. And it’s going to save the government a fortune.

Recent reports have shown the US Treasury to be in trouble financially. This from USA Today:

For the first time in U.S. history, the cost of manufacturing both a penny and a nickel is more than the 1-cent and 5-cent values of the coins themselves. Skyrocketing metals prices are behind the increase, the U.S. Mint said in a letter to members of Congress last week.
The Mint estimates it will cost 1.23 cents per penny and 5.73 cents per nickel this fiscal year, which ends Sept. 30. The cost of producing a penny has risen 27% in the last year, while nickel manufacturing costs have risen 19%.

You don’t need to be a financial genius to know that this is just throwing good money down the drain. And plans are already afoot to do away with smaller currencies and ask retailers everywhere to round prices to the nearest 10 cents. This will also stimulate more money for small business, as $2.99 will round to $3.00, giving the store or business an extra penny on each purchase.

However, a plan that is being implemented immediately is the At-Home Money Printing Stimulus. All it requires is a computer and a printer, and you can basically use your home office to print out all the money you need, with your printer being the new ATM.

Using a simple software installation, you will log into your bank account and make a withdrawal, as you would from an ATM. Instead of getting traditional cash, you will instead receive image files (PDFs) that contain the money. For those of you wondering about fraud, each new note will have a unique barcode. See sample below.

Once the barcode has been used once, it will deactivate. So, if anyone tries to photocopy the bills, they will be out of luck. The unique barcode also helps the government track your spending habits. So, if you download $100 and use it at Crate & Barrel, that information will be relayed back to a database, helping the government plan for future stimulus bills.

As almost every store has the ability to read barcodes, this new technology can be implemented straight away. Any smaller outlets without barcode scanners will continue accepting cash, checks and credit cards.

All major banks are on board, and you can download an instruction manual here. It certainly won’t be for everyone, but it’s a step in the right direction and the millions it will save the US in printing costs can be spent on paying down our national debt.

This article is from Paul Michael of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Five alternatives to 0% yield U.S. treasuries

Xin Lu — Fri, 12 Dec 2008 01:10:37 +0000

This week the 4 week T-bill rate was driven down to 0% and the demand for these treasuries was astounding. It seems that investors are so pessimistic that they are willing to accept no yield for the safety of their principal. If you have been following the markets for the last few months it does seem like every other asset is falling. So, where could we put our cash if we do not want 0% yield treasuries?

1. I-Bonds - If you believe in the safety of treasuries, then you should have the same faith in I-Bonds because they are also issued by the United States Government.The current fixed rate is 0.7% and semi-annual inflation rate is 2.46% so the composite rate is 5.64% for at least six months.

2. Certificates of deposit- Practically all banks are still offering certificates of deposit with yields higher than 0%. The Fatwallet forums maintains a good list of the current rates at various institutions.

3. Checking/savings account - Most checking accounts do not pay interest, but your money is free for use. Many online and offline savings accounts are still paying decent yields above 2% and they are FDIC insured up to $250,000 per account.

4. Pay off debt - Instead of buying 0% treasuries, it would definitely be better to reduce any debt you have with any extra money you have. If you keep your money in an investment that pays nothing but your debt rises at a positive interest rate, then you will be able to pay less debt in the future with the money you have now.

5. Bury it - You may laugh at this one, but some people are dead serious about making their own treasure maps and burying their money. This may not be a bad idea in case there is some true catastrophe and there is no way to reach your financial institutions, but then again, someone could find your stash and dig it up.

I am sure that you can think of many other places to stash your cash amidst this very pessimistic investing season. Giving an interest free loan to the United States government may be seen as patriotic, but it is definitely not your only safe bet.

This article is from Xin Lu of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Update on money fund guarantee program

Philip Brewer — Mon, 29 Sep 2008 15:40:58 +0000

The key thing to know about the Temporary Guarantee Program for Money Market Funds that the Treasury announced 10 days ago is that it only guarantees the money that you had in the money fund on that date. Any money you have in the fund that exceeds your balance on September 19th is not guaranteed--those shares are only worth their net asset value.

I posted when the Treasury announced the guarantee plan. Now the Treasury has released the details, in the form of a press release and an FAQ.

The plan was created for a simple reason: Money funds are key buyers of commercial paper and jumbo bank CDs. If shareholders in money funds chose to switch to more secure assets, the money funds would have no choice but to sell those assets--and if that happened to all money funds at once, there'd be no buyers. The result would have been a sudden collapse in the value of what had previously been the safest non-government assets.

With that in mind, the odd structure of the guarantee plan makes a certain amount of sense. They don't want to get into the business of guaranteeing money funds. Doing that would have a pernicious effect on the incentives of money fund managers. (Currently they compete on safety and yield. If all funds were equally safe--guaranteed by the Treasury--they would only compete on yield, driving fund managers toward the riskiest allowed investments.)

Now, though, it is only old money that's equally secure in all money funds. Any new money will only be as secure as as the assets of the fund, meaning that anyone looking for a place to put their money still needs to focus on safety. That should work to keep the incentives of the fund managers properly aligned.

Two other points:

The plan is temporary, initially in place for just three months, it can be extended by the Secretary of the Treasury for up to one year.
The plan only applies to money market funds that choose to join and pay a fee. The Treasury says to contact your fund to learn if they're participating in the program. (Individual investors can't sign up for the program individually.)

Whatever money you had in a money fund 10 days ago is as safe as any investment can be in these troubled times (assuming your fund participates in the plan). For any new cash that you'd like to put away for the future, picking a money fund will require the sort of research you should have been doing right along.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Me too, Secretary Paulson!

Philip Brewer — Sun, 21 Sep 2008 16:08:05 +0000

Dear Secretary Paulson: I've looked over the fact sheet on the proposal to give the Treasury the authority to purchase "troubled assets," and although I have some doubts about the wisdom of the program, if there's going to be one, I want to get in on it!

With that in mind, I thought I'd sent you a quick list of some of my troubled assets, so that you can make sure the appropriate people know about them, when they start buying. (I have no doubt that others are doing much the same thing, so I wanted to be sure to get my request in early.)

I guess my biggest category of "troubled asset" is clothing that doesn't fit. Not only do I have quite a bit of money sunk into these assets--which are worth much less than I paid for them--but they've got my closet filled to the point where there's scarcely any room for my wife to store her wool! (She's a spinner and weaver, so she has lots of wool to store.) Because of that, I'd be willing to let my old clothes go for a substantial discount from their original cost. I don't know if the Treasury would have much hope of realizing a profit on these assets--but if the dollar goes on losing value, we might no longer be able to afford to import clothes from abroad, in which case, they just might have more value than I realize.

The next category of "troubled asset" that I'd like the Treasury to take off my hands are old books. I've got lots of them. Since the internet has made it easy to buy and sell used books, the value of most used books has plummeted! Check the prices of used books at amazon.com, and you'll see that many books are worth less than the cost of shipping them--even if you ship them book rate! (They call that "media mail" now, but I'm old enough to still think of it as book rate.) Anyhow, these assets are quite troubled. They are not only worth a lot less than what I paid for them, they're also (like the old clothing) taking up a lot of room--my book cases are completely full, and I've got stacks of books all over the place!

I wanted to mention those two categories first, because they're the most important to me. I understand, though, that you're mainly focused on financial assets. My own financial assets have held up pretty well so far, but I do have some stock in a certain former employer that's done quite poorly. I can't really say it's "clogging up" my balance sheet, but if the Treasury could take it off my hands and get the economy going again, it could be a win-win.

Thanks very much for your thoughtful consideration, Secretary Paulson, and I hope you'll let the appropriate people know so that my trouble assets can be included when you start buying. I want to assure you that my old clothes and books can be had for a tiny fraction of the $700 billion that you're talking about spending. I'll need much less than 1% of the money--much, much less! You don't have to worry about me hogging the program. And, thanks again.

Yours sincerely,
Philip Brewer

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

A Simple Guide to Series I Savings Bonds (I-Bonds)

Xin Lu — Wed, 23 Apr 2008 00:02:30 +0000

After the recent interest rate cuts by the Federal Reserve many of my bank and money market interest rates plummeted. Now the best yield I have is on my Series I Savings Bonds issued by the United States Treasury. These bonds are also known as I-Bonds and their yields fluctuate according to inflation. Currently, the yield is 4.28% and that beats all of my other cash investments. Here is some information on the interest rate on I-Bonds and the advantages of owning these bonds.

The yield on I-Bonds changes every May 1st and November 1st. The composite interest rate is based on a fixed rate and a variable portion that fluctuates with the semiannual inflation rate. The formula used for the yield is:

[Fixed rate + (2 x Semiannual inflation rate) + (Fixed rate x Semiannual inflation rate)]

The fixed rate is currently 1.20%, but it is expected to drop on May 1st. However, the inflation rate has gone up so the variable rate will be higher than before. If you lock into the current fix rate, it is expected that the next composite rate would be above 6%.

You have to hold an I-Bond for a year before you can cash out, and if you cash in your I-Bonds before five years you will lose 3 months of interest. However you can take advantage of the bond's interest accrual rules to lose only 1 month of interest. It is a bond that gives you the whole month's interest no matter which day you purchase or sell it. As an example, you can buy the bond on April 30th this year and sell it on May 1st next year. Your holding time is one year, and you are supposed to lose three months of interest, but you actually only lose one month and two days' interest because you actually held the bonds for only one day in the two months you performed the transactions. If you choose not to sell the bonds they will continue to earn interest for 30 years.

There are several advantages to owning I-Bonds. First, taxes on these bonds are deferred so you can choose to pay them only when you sell them. Second, local and income taxes are not charged on all Treasury Bonds so in a high tax state like California the effective yield is even higher. Third, you can reasonably predict what the next interest rate would be according to the CPI reports. Finally, it is a relatively safe investment because it is backed by the United States Treasury.

Currently you can only buy $5000 of I-Bonds online per year through http://treasurydirect.gov, but you can also buy $5000 of paper notes through a bank. There should be no transaction fees to buy I-Bonds and as long as the US Government does not fail completely you are guaranteed to get your money back. The current I-Bonds yield is definitely better than any CD or savings account out there, but if you make a purchase make sure you do not mind leaving your money with the government for at least a year.

This article is from Xin Lu of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread: