Treasury Bills, Notes, Bonds and TIPS: How US Treasuries Work

When the federal government needs to borrow, it sells Treasury securities. Those IOUs, often simply called Treasuries, are among the most widely held and actively traded investments in the world, and their yields serve as the reference point for mortgage rates, corporate borrowing costs and the discount rates analysts use to value stocks. Individuals can own them directly, often for as little as $100.

The five main types

All marketable Treasuries are backed by the full faith and credit of the US government. They differ mainly in how long they last and how they pay interest.

TreasuryDirect lists the current terms on its marketable securities page, as the Treasury occasionally adds or adjusts maturities.

Bills

T-bills pay no coupon. You buy them below face value and receive the full face value at maturity. If you pay $990 for a bill that matures at $1,000, the $10 difference is your interest. Because they are short, their prices barely move when rates change, which makes them a common parking place for cash.

Notes and bonds

Notes and bonds pay a fixed coupon twice a year and return face value at maturity. The coupon is set at auction. After that, the market price moves as interest rates change: when rates rise, existing notes paying lower coupons become less valuable, and vice versa. The longer the maturity, the bigger that effect.

TIPS

Treasury Inflation-Protected Securities adjust their principal with the Consumer Price Index for All Urban Consumers (CPI-U). The fixed coupon rate applies to the adjusted principal, so interest payments rise with inflation. At maturity you receive the greater of the adjusted principal or the original principal. One quirk: the inflation adjustment to principal is generally taxable each year even though you do not receive it in cash until maturity, which is why many investors prefer to hold TIPS in tax-advantaged accounts.

FRNs

Floating rate notes pay interest that resets based on the 13-week T-bill auction rate plus a fixed spread. Because the rate keeps adjusting, their prices stay relatively stable.

How auctions work

The Treasury sells new securities through regular auctions on a published schedule. You can bid in two ways:

• Noncompetitive bid: you agree to accept whatever yield the auction determines and are guaranteed to receive the amount you request, within limits. This is how nearly all individuals buy.
• Competitive bid: you specify the yield you will accept. Large institutions and dealers use this; if your yield is too high, you may get nothing.

The auction sets one rate for everyone. Results, including the high yield and the demand from different types of buyers, are published shortly after each auction.

Where individuals buy

TreasuryDirect.gov is the government's own site. You buy at auction with no fees and hold the securities in an account linked to your bank. The limitation: to sell before maturity, you must first transfer the security to a brokerage account, which involves a waiting period after purchase.

Brokerage accounts let you buy new issues at auction (often with no commission) and also buy and sell existing Treasuries on the secondary market at current prices. This is more flexible if you might need the money before maturity.

Treasury funds and ETFs hold portfolios of Treasuries of a given maturity range. They never mature, so their value continues to fluctuate with rates, but they offer convenience and daily liquidity.

Separate from these marketable securities, the Treasury also sells savings bonds (Series I and EE) only through TreasuryDirect. They cannot be traded, have annual purchase limits and follow different rules.

Yield, price and what you actually earn

Two numbers appear on any Treasury quote:

• Price, quoted as a percentage of face value (for example, 99.50 means $995 per $1,000).
• Yield to maturity, the annualized return if you buy at that price and hold to maturity, including all coupons.

If you buy and hold to maturity, interim price swings do not change your outcome: you receive the coupons and the face value. Price changes matter only if you sell early, or if you own a fund.

How Treasury interest is taxed

• Federal: interest is taxable as ordinary income. For T-bills, the discount is treated as interest in the year the bill matures or is sold.
• State and local: interest on Treasuries is exempt from state and local income taxes.
• Reporting: TreasuryDirect and brokers issue Form 1099-INT; check IRS Publication 550 for details.

The state exemption can make a Treasury yield worth more after tax than an identical-looking yield on a CD or corporate bond, especially in high-tax states. Comparing after-tax yields is the fair test.

Risks that remain

Treasuries are about as close to free of credit risk as a dollar investment gets, but they are not risk-free:

• Interest rate risk: a long bond can lose significant value before maturity if rates rise.
• Inflation risk: fixed payments buy less if inflation runs high (TIPS address this).
• Reinvestment risk: when a short bill matures, the rate available for the next one may be lower.

Bills versus money market funds

For cash savings, T-bills are often compared with Treasury or government money market funds, which hold bills and similar short-term instruments. A money market fund offers daily liquidity and automatic reinvestment, and its yield adjusts continuously as rates change. Holding bills directly avoids the fund's expense ratio and locks in a yield until maturity, but requires rolling them over as they mature. The state tax exemption applies to Treasury interest received directly; for funds, it generally applies only to the portion of income that comes from Treasury securities, which the fund reports each year.

Building a simple ladder

A common approach is a ladder: splitting money across several maturities, say bills or notes maturing every few months or every year. As each matures, the proceeds are reinvested at the long end. A ladder smooths out the effect of changing rates and provides predictable access to cash. It works in either TreasuryDirect or a brokerage account, and it is a practical way to see how the whole yield curve behaves over time.

This article is for education only and is not investment or tax advice.