Treasuries: Pros and cons

Government issues aren't all the same. Here's a rundown of the differences, as well as the pros and cons of each type.

By Dennis Murray
Senior Editor

Many financial advisers are recommending Treasury securities. After all, they remain one of the only safe bets around—a big draw in these uneasy investment times. Moreover, earnings on all government issues are exempt from state and local taxes.

But it's important to remember that Treasuries don't escape federal taxes. They're not all the same, either. Knowing which ones to choose could mean an extra percentage point or more in return each year.

Because no one can predict which way inflation and interest rates will go or when they'll change, it's smartest to own a variety of Treasuries with different maturities. Here's a rundown of the pros and cons of each type. You can buy Treasuries through brokerages, banks, and other financial institutions.* But better yet, with the exception of 30-year Treasury bonds, which are no longer issued and now trade only on the secondary market, you can purchase almost all of the ones listed here via the links you'll find at TreasuryDirect (www.treasurydirect.gov ; 800-722-2678), without paying a commission. You'll need a broker only for zero-coupon Treasuries.

Treasury bills

What are they? Known as T-bills, these short-term securities mature in a year or less from the date they're issued. You buy them for less than their face (par) value, and instead of receiving periodic interest payments you get face value when the bills mature. If you sell a bill before it matures, your interest equals the difference between the discounted purchase price and the sale price.

Pros: They won't tie up your money for extended periods, which makes them ideal for times when interest rates are slowly rising. You can transfer T-bills to someone else, or buy and sell them on the open market.

Cons: Earnings are taxed at regular income rates, which can be as high as 35 percent.

Fixed-rate Treasury notes

What are they? Treasuries that pay interest at a fixed rate every six months until maturity. When they mature, you get back their face value, as you would with T-bills. Unlike Treasury bills, which are sold at a discount, you pay full face value for Treasury notes.

Pros: Two-, three-, five-, and 10-year notes are available, providing an excellent opportunity to "ladder"—meaning stagger maturities to take advantage of varying interest rates. Also, unlike savings bonds, Treasury notes can be transferred to someone else.

Cons: Because of their longer maturities, inflation may erode the fixed rate to the point where you're essentially losing money.

Inflation-indexed Treasury notes

What are they? Known as TIPS, Treasury inflation-indexed securities offer returns tied to the Consumer Price Index. Total returns are the sum of a fixed interest rate and a second rate that reflects inflation and is adjusted every six months. Payments are made semiannually. Only TIPS with 10-year maturities are currently available; the government offers them four times a year.

Pros: These make good, long-term hedges against inflation, because of the link to the CPI. That's why TIPS have been called "safest of the safe" among Treasury bills, notes, and bonds.

Cons: A TIP may not earn as much as a plain vanilla Treasury of the same duration if inflation stays low for an extended period. Moreover, gains on TIPS are subject to federal income tax in the year they're earned, even though you won't receive them until the notes mature or you sell them.

Zero-coupon Treasuries

What are they? Treasuries that pay compounded interest at maturity. Zero-coupons are sold at deep discounts to face value. The longer the maturity—the highest of which is currently 10 years—the less you'll pay for each note.

Pros: Thanks to the power of compounding, you'll generally earn more money with a zero-coupon than you would with a Treasury note that has the same maturity and pays interest periodically.

Cons: As with TIPS, you'll owe income tax on the interest that accrues each year. For this reason, many financial planners think it's smartest to hold TIPS and zero-coupons in a tax-deferred investment account, where their earnings won't be taxed until you withdraw your money.

Series EE savings bonds

What are they? Now known as "Patriot Bonds," Series EE savings bonds earn 90 percent of the average yields on five-year Treasury notes for the preceding six months. They increase in value monthly, instead of every six months like TIPS do. Designed for buy-and-hold investors, they're priced at half of their denomination; for example, a $100 bond costs $50. Those purchased in June 2003 or after mature in 20 years.

Pros: You can defer federal taxes on your earnings for up to 30 years, after which EE bonds stop earning interest. They're also available in denominations as small as $50.

Cons: These bonds aren't transferable. Moreover, if you cash an EE bond before it's five years old, you'll get back your original investment but lose the last three months' of interest. For instance, if you sell after 36 months, you'll be credited for the first 33 months' interest.

Series HH savings bonds

What are they? Created for those who want current income, Series HH bonds pay interest every six months, and the rate stays locked for 10 years. They sell at par and don't rise in value.

Pros: Denominations run as high as $10,000, and interest is credited every six months to your checking or savings account.

Cons: They're available only in a swap for Series EE/E bonds or after reinvesting the proceeds from matured Series H bonds. The smallest denomination is $500.

Series I savings bonds

What are they? A second, more-flexible type of inflation-indexed security.

Pros: You can buy them in denominations as small as $50, as opposed to TIPS, which require a $1,000 minimum purchase. And, unlike gains on TIPS, you can defer paying taxes on interest on I bonds until you cash them, or until they stop earning interest after 30 years.

Cons: The same as the knocks against Series EE bonds—you must hold them for at least five years and can't transfer them to someone else.

*Because yields on Treasuries vary depending on their issue dates, maturities, and selling price in secondary markets, we've refrained from listing yields in this article. For current information, see The Wall Street Journal or Bloomberg.com (www.bloomberg.com). Click on "Market Data," then "Rates & Bonds."

 

Dennis Murray. Treasuries: Pros and cons. Medical Economics Dec. 5, 2003;80:37.