All bonds face certain risks, but the greatest advantage of U.S. Treasury notes and bonds is that they are the benchmark against which all U.S. corporate and municipal bonds are traded because they are considered the safest bonds available. Treasury notes come in short-term maturities from one year to five years, and intermediate maturities from five years to 12 years. Treasury bonds come in maturities from 12 years to 30 years.
Obligations of the United States Treasury carry the full faith and credit guarantee of the United States Government that interest and principal will be paid in a timely manner. Regardless of fears that the Treasury will default on its bonds, the Treasury can always print more money to pay off its bond obligations. This ability to print money sets Treasury bonds apart from corporate and municipal bonds, which realistically face the risk of default.
Interest Rate Risk
Interest rate risk affects all bonds, regardless of credit. When market yield rates rise, the dollar value of bonds declines. When market yield rates fall, the dollar value of bonds rises. The term to maturity greatly affects the dollar price of bonds as market yields fluctuate. The shorter the maturity, the less a given change in interest rates will affect the dollar price. To understand this, consider an imaginary note and bond: The note has a 5 percent coupon and matures in seven years. The bond has a 5 percent coupon and matures in 30 years. Both bonds were issued at $1,000, or par. If market yield rates rise to 8 percent, the note will be worth only $841.73 but the bond will decline to $660.66 in price. If rates decline, the note and bond will rise, and the rate of increase will be similar. Because of this, when interest rates are likely to fall, it is better to be in bonds with as long maturities as possible because they will experience greater price appreciation than notes. When interest rates rise, however, the shortest notes are the safest and their short maturities will allow you to reinvest your money at higher interest rates when your original holdings of notes mature.
During periods of high interest rates, investors flock to long bonds for the locked-in yield. They are also popular during periods of declining rates because of the profit potential. However, when interest rates start to rise, professional portfolio managers dump their long bonds and buy short maturity notes and money market instruments. When this happens, Treasury bonds still have better liquidity than long corporate bonds, but it may be difficult to get a good price for them. Of course, in light of the possibility of not being able to sell a corporate or municipal bond quickly, a Treasury bond is a better deal.
One problem that bonds have, which is not normally a factor with notes, is call risk. When a long bond is priced during high interest rate times, it normally carries a five, seven or 10-year call date. This means that if interest rates are lower when the call date rolls around, the bond will be called at par or a price already set in the bond prospectus. Investors holding these called bonds will lose them, and get paid their principal. The Treasury will then issue new bonds at a lower interest rate. Notes rarely have call dates, so if you expect interest rates to decline, you should buy the longest non-callable note available.