Stories of government overspending and fiscal meltdown fill the news. Understandably, many people might rank the U.S. government down somewhere with an irresponsible friend when it comes to paying off loans. Yet every day, citizens, corporations and foreign sovereignties float loans to Uncle Sam -- $3.9 trillion worth in 2003 [source: Government Accountability Office]. And they get paid back, with interest. It's not some "free money from the government" scheme hawked on late-night TV. It's a financial tool as old as the nation itself: Treasury bonds.
A bond is money loaned to a business or government with the pledge that it will be returned at a certain time -- called the maturity date -- along with an agreed-on percentage of interest. Bonds issued by the U.S. Treasury Department come in increments of $100. They pay interest every six months until they mature at 30 years.
The Treasury issues bonds for two main reasons. One is to pay down the national debt. Another is to influence economic growth. Issuing bonds increases or decreases the amount of money available to banks. That affects interest rates, which affects whether you can borrow money to buy a car or to open a hot dog stand.
Despite the much-publicized downgrading of the United States' credit rating, Treasury bonds are considered risk free. The government has never failed to pay back a bond. However, with low risk comes low interest rates. Bonds are the tortoise in Aesop's fable of the tortoise and the hare, slowly but surely returning a tidy little profit. They're a good choice as long-term investments, balancing out shorter-term, higher-risk, higher-returning investments in a portfolio.
Unlike the $50 that your friend wheedles from you, bonds are marketable. Like houses, they might be bought and sold many times before they mature. Their reliability makes them popular, so you'll usually find a buyer or a seller. Also, the interest is free from state income tax.
Also like a house, a bond's price can rise or fall depending on economic factors. But money is different from a house, you say. A $100 bill is always worth $100, right? That's a good question, and it's where we'll start our investigation. On the next page, learn how your interest in bonds can yield a profit.
Treasury Bond Auctions
Normally, the Treasury sells bonds at auction four times a year. The dates and the total value of the bonds issued are announced in major newspapers and financial publications.
A bond sale is actually two simultaneous auctions, with primary dealers as the main bidders. Primary dealers are large, institutional investors that trade directly with the Treasury. Before the auction, they submit competitive bids, which state the lowest yield they'll accept. (Yield, you'll recall from economics class, is your return on an investment. It equals the interest the bond earns divided by its purchase price). For example, Cantor Fitzgerald might bid for a $2 billion bond and a yield of 4.15 percent. Bids are taken until the auction starts. At that time, the Treasury uses these bids to set the bonds' yield, and thus the interest rate.
If you're not a large financial institution, you can take part in an auction by placing a noncompetitive bid, which is simply the dollar amount of the bond you want. With a noncompetitive bid, you accept whatever yield and interest rate are established, which you won't know until the auction closes. This transaction is conducted conveniently through the Treasury's online service, TreasuryDirect. During an auction, all noncompetitive bids are filled first. Competitive bids are then doled out until the entire issue has been sold.
But as we said, bond prices change over time. You can sell your bond at any time before it matures to take advantage of this fact. For example, suppose you own a bond that pays 5 percent interest. Newly issued bonds, however, are paying 4 percent interest. Your bond, with its greater return, is comparatively more valuable. You could sell it at a premium, a price higher than its face value that depends on the inflation rate, predicted interest rates and other factors. The buyer also pays you the interest the bond has accrued since the last payment date.
On the other hand, if new issues are returning 6 percent interest, your bond is less valuable. You might decide to sell it at a loss, or a discount, in order to buy a higher-returning bond.
To trade in bonds requires a primary dealer or a broker. To expand beyond bonds to more complex investment packages takes other expert advisers. Invest a few minutes reading the next page for a look at how bond brokers and mutual funds work.
Treasury Bond Brokers and Mutual Funds
Like restaurants, Treasury bond brokers vary in services offered. Some wait on you hand and foot, others only take and deliver your order. Let's look at the options:
- Full-service brokers, as the name implies, do it all. They help you define your investment goals and then research and choose the bonds to meet them. They have the greatest number and variety of issues for sale. Some full-service brokers are also primary dealers. Service has a price, of course. Maintenance and transaction fees can total several hundred dollars a year.
- Your bank may also trade in bonds. While it may offer many services for many different fees, it will be limited to, and biased toward, the bonds it owns.
- Discount brokers take your orders to buy and sell but leave the decision making up to you. They also carry fewer types of bonds. If you want a 2008 issue with a 5.75 percent yield, for instance, they may have to buy it from a primary dealer. Their fees run about 20 percent to 30 percent less than those of full-service firms.
- Online brokerage services provide professional resources to the astute amateur, including real-time market updates and profit-loss calculators. Individual investors use these services to make trades online for up to 95 percent less than trades made through a full-service broker.
Treasury bonds can be an ingredient in investment buffets called mutual funds, which are actually companies jointly held by a group of investors. A mutual fund's holdings, or portfolio, may consist of stocks, bonds and other investments. They're managed by outside advisers who choose the portfolio's makeup -- you may pay those advisers fees of up to 8.5 percent of the cost of the fund when you buy or sell it.
Compared to Treasury bonds, mutual funds are more accessible and flexible. You can buy an almost unlimited number of shares and sell them at will. The portfolio approach provides security through diversifying (that is, spreading out) your investment: If bond prices are plummeting, stocks might buoy up the fund's return.
Mutual funds fall into three main categories based on the type of investment:
- Bond funds may comprise long-maturing Treasury and municipal issues (income funds) or shorter-lived Treasury bills and notes (money market funds).
- Stock funds, or equity funds, promise varying degrees of rewards and risk depending on the earnings of the companies it hold shares in and the general stability of the stock market.
- Balanced funds strive to offer both security and rewards by holding both bond and stocks.
Having stocked you with information, we'll wrap up this discussion on the next page with points to ponder before purchasing a Treasury bond.
Tips for Buying Treasury Bonds
Like choosing a career or a life partner, buying a Treasury bond can be a rewarding 30-year relationship. The key is knowing what to expect before signing on the dotted line.
First, weigh the benefits against the costs. When you buy a bond, in exchange for a steady, reliable return you accept relatively low interest rates. That means you need to invest a larger sum in bonds than in stocks or other Treasuries in order to make the same return. Also, while the interest pays every six months, you won't see your initial investment money for up to 30 years, assuming you keep the bond to maturity. That could be a problem if you need it before then.
On the other hand, bonds require less maintenance than stocks or a mutual fund. Barring some drastic swing in interest rates, you can feel comfortable holding onto your investment, reaping its returns until it matures. And since many brokers charge a fee per transaction, that can save money in the long run.
If you're willing to accept the conditions, take time to compare brokers. Decide what features are most important. Are you a confident investor who only needs an authorized agent to make trades? Or do you want the reassurance of being able to phone, e-mail or text an individual broker with questions and concerns? Either way, you'll want a competent broker who understands your financial goals and will help manage your investments to meet them. Ask for references to see how experienced he or she is with clients of your means and situation. And, although most brokers operate ethically, it can't hurt to run background checks on your candidates through the Securities and Exchange Commission's Investment Adviser Public Disclosure Web site.
Making money is the point of this whole venture, so learn how -- and how much -- brokers charge for their services. Besides transaction fees, they may charge a commission or flat fee based on the size of the bond. Also, brokers typically charge a markup when they sell you a bond, the amount of which they don't have to disclose. Again, ask. A markup of 1 to 2 percent of the bond's price is considered fair.
We hope this primer sets you on the path to years (at least 30) of happy investing. As guidance on using your riches, we suggest this quote from novelist Miguel de Cervantes, who set many of his characters on similarly long-term quests: "The gratification of wealth is not found in mere possession or lavish expenditure, but in its wise application" [source: Forbes].
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