Government Bonds & Interest Rates

by Tim Plaehn

The U.S. government issues bonds in the form of Treasury bills, notes and bonds. U.S. Treasury securities are backed by the full faith and taxing power of the U.S. government and are considered to be the safest debt investments. The rates on Treasury securities are the benchmarks for other debt securities.

Types

The Treasury divides government bonds into three classes. Treasury bills are issued with maturities up to 52 weeks and sold at a discount to the maturity value. Treasury notes have maturities from two to ten years at issue and pay a fixed rate of interest with payments twice a year. Treasury bonds also pay interest twice a year and are issued with a 30-year maturity.

Rate Auctions

The Treasury sells the various types of government bonds through weekly Treasury auctions. The interest rate of the specific securities is determined by a competitive bidding process. Large financial institutions place bids for the rate of interest they will accept on the bonds. Competitive bids are used to fill 35 percent of each auction and the balance goes to non-competitive bids at the highest winning rate of the competitive bids. Once the bonds are issued they will continue to pay the issue rate until maturity. There is an active secondary market in government bonds where investors buy and sell previously issued Treasury securities. The rates in the secondary market follow the rates set at Treasury auctions.

Yield Distribution

The current rates for the different maturities of government bonds is called the Treasury yield curve. The yield curve shows how rates change as maturities get longer. The typical yield curve has rates increasing as maturities lengthen. If short term rates rise to be higher than long term rates, the yield curve is said to be "inverted." The short end of the yield curve is most influenced by the policies issued by the Federal Reserve Board (the Fed). Longer term rates are market driven by bond investor expectations concerning future prices and inflation rates.

Function

After a bond is issued by the Treasury, the rate it pays stays constant until the bond matures and the face amount is paid to the bond holder. The rate of interest paid by the bond is called the coupon rate. For example, if a Treasury bond has a coupon rate of 6 percent, a $10,000 bond will pay $600 per year in two semi-annual payments of $300 each. The secondary market adjusts the value of existing bonds by increasing or decreasing the market price of the bonds based on current rates. A bond will trade at a premium or discount to its face value based on the current rates and the bond's coupon rate.

Bonds and Interest Rates

Investors should know the relationship between government bond prices and changing interest rates. Rising rates will cause bond prices to decline and falling interest rates will result in higher bond prices. Longer term bonds are affected more by interest rate changes than short term bonds. Investors want to own long term bonds in a falling rate environment to lock in higher rates and have the market value of the bonds increase. Rising rates dictate owning short term bonds so the principal can be received at maturity and reinvested at new higher rates.

About the Author

Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.

Photo Credits

  • Department of Treasury Building image by dwight9592 from Fotolia.com