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All bond strategies
 

Buy Treasury Bond

Who Should Run It

Rookies and up

When to Run It

  • Degree of sentiment on the stock market: -3 to +1
  • Strongly bearish to mildly bullish

Bonds can be run at any time as a key component of a diversified investment portfolio.

Broader Market Outlook

Although it is possible to make sound investments in virtually any market environment, it’s usually a good idea to evaluate the Fed’s current and anticipated policy on interest rates before and while holding bond investments. If your bond’s coupon rate is higher than the current interest rate target set by the Fed, your bond is going to look pretty sweet to investors, driving its price up. But if the Fed were to bump up interest rates to a rate higher than your bond’s coupon, your bond won’t look so hot compared to new bonds issued with the higher coupon rate. Your bond’s price would correspondingly drop in the secondary market.

Other concerns are market jitters or inflation. When there’s great uncertainty in the stock market, there’s a “flight to quality” among investors. Treasuries are usually the preferred vehicle in this case. Treasury Inflation-Protected Securities (TIPS) might be just the ticket if you fear inflation is on the rise.



About the Security

Bonds are investments known as “debt securities” or “fixed-income securities”. For the retail investor, bonds are bought and sold through a broker, like TradeKing, who charges a commission and may also charge a markup or markdown when acting as principal. Each bond you own represents a loan you have made to the issuer. You can think of this as an IOU. In exchange for the loan, you’ll be paid a specified rate of interest over time.

In general, the goal when investing in bonds is to receive a competitive coupon (interest payment) as scheduled and to receive full repayment of your loan at maturity. Neither goal is without risk. A change in interest rates can have a huge impact on a bond’s price. Interest rates and bond prices are like a seesaw: when one goes up, the other moves down. If you decide to sell a bond investment prior to maturity, it’s possible you may incur a capital loss.

The Quick Start Guides for Bond Basics and Bond Investments cover many important topics when getting started with bonds. Before investing carefully consider your investment objectives, the risks, transaction costs and fees.

The Strategy

Treasury bonds – also known as “Treasuries” or “T-Bonds” is the umbrella term for different types of bonds issued by the U.S. Treasury. Treasuries come in three main types based on the time frame of the loan:

  • T-Bills – the shortest-term variety maturing in one year or less
  • T-Notes – mid-range loans with maturities of two, three, five and ten years
  • T-Bonds – the longest-term loans maturing in 30 years.

Treasuries are widely regarded as virtually risk-free investments – but in exchange for that safety, you’ll have to be willing to accept a correspondingly modest return.

T-Notes and T-Bonds pay a rate of interest every six months, or twice per year until the bond matures. T-Bills operate a bit differently. They’re issued in the primary market at a discount to their face value of $1,000 per bill. Instead of earning a rate of interest, you’d get $1,000 when the bill matures.

Another form of Treasuries are Treasury Inflation-Protected Securities or TIPS. TIPS are market securities whose principal is tied to changes in the Consumer Price Index, or CPI. TIPS principal increases with inflation (rises in the CPI) and decreases with deflation (decline in the CPI).

TIPS pay a fixed rate of interest twice annually, and that interest also fluctuates with current inflation levels. Think of it this way: if inflation does kick in as you’d feared, your TIPS principal would increase accordingly. Then you’d be paid a fixed rate of interest on a higher principal, effectively resulting in a higher rate of interest. You can buy TIPS in five-, ten- or twenty-year maturities in increments of $100 each. Upon maturity you get either the inflation-adjusted principal or the original principal.

Treasuries are virtually risk-free

Treasuries can be considered the Cadillac of secure loans. The Treasury has never defaulted on a federal loan, and its debt securities are considered virtually risk-free - as safe as cash. (However, the Treasury’s credit-worthiness won’t prevent losses if selling your bonds prior to maturity.) In fact, Treasuries are considered so bulletproof that risks associated with debt securities the world over use Treasuries as the prime benchmark of safety. Ultimate safety comes with tradeoffs, however. Treasuries pay the lowest rate of interest of all bond types in exchange for being an extremely sure thing.

Like other Treasury bonds, TIPS are theoretically default risk-free. However, you do face significant risks in the event that deflation occurs. Deflation, or a drop in the CPI, means your principal would be correspondingly adjusted downward, so your interest payments would be less than if the CPI had stayed flat or showed evidence of inflation. In a deflationary environment, then, TIPS products could expose you to significant capital losses. At maturity, though, a useful safeguard kicks in: if the adjusted principal is less than the security's original principal, you’d be paid the original principal. However, no such safeguard exists against deflation before maturity.

You might opt for Treasuries because:

  • Bonds are a part of your asset allocation plan. You’ve decided to invest a certain percentage of your portfolio in bonds.
  • Your top priority is capital preservation, with minimal risk. If you can’t stomach any risk, Treasuries offer the lowest-risk investment going.
  • You want a highly liquid market for your bond investments. If you need to cash out of your Treasuries, chances are high you’ll find an investor willing to take the security off your hands at a competitive and acceptable price.

Treasuries can be used in a common bond strategy known as laddering. This involves spreading your risk over a series of different maturities, while maintaining an average maturity that suits your investment goal’s time horizon.

Time Horizon

Treasuries are used across all time frames, from the extreme short-term to the extreme long-term. Your time horizon may vary according to your investment objectives, asset allocation, risk tolerance and available capital. Try to choose a bond with a maturity date that coincides with when you expect to need the money.

Some investors gradually shift from higher-risk investments like stocks or other bonds to Treasuries as the time horizon for a given financial goal approaches.

When to Get In

You might buy Treasuries if:

  • You want to transition assets into a low risk investment as your time horizon for reaching a financial goal approaches.
  • You are super-nervous about the stock market.
  • You don’t have a clear outlook on the market as a whole.
  • You expect interest rates to decrease in the future.
  • You expect inflation to rise and invest in TIPS.

When to Get Out

Treasuries are usually purchased with the intention of holding them until maturity. That said, you might liquidate your holdings in Treasuries if:

  • You need the money for a specific purpose.
  • You are comfortable with the risk-reward relationship offered by the stock market.
  • You have a clearer outlook on the stock market.
  • You expect interest rates to increase.
  • You expect inflation to stabilize or deflation to occur and liquidate TIPS.
  • The bond reaches its maturity date.

Investment Management

Treasuries are usually purchased with the intention of holding them to maturity, which makes for a low-maintenance investment. The interest payments you receive while holding T-Notes or T-Bonds deserve more attention. Each individual coupon payment may not seem like much money. However, stashing these payments in a savings account over the course of a year can amount to a nice chunk of change. Consider reinvesting these funds to purchase additional bonds on an annual basis.

Volatility Factor

Fluctuation in bond prices is a factor of changes in interest rates and changes in Credit quality. If you hold your bonds until maturity, the volatility they experience between now and then doesn’t change the fact that you will receive the full face value at that time. In general, prices of Treasury securities tend to fluctuate the least when compared to other bonds due to their very high credit-worthiness (and therefore their low risk). Increased time-to-maturity, higher coupons, longer duration, and bonds trading at a discount are all additional factors which can increase the volatility of bond prices. Be sure to choose a bond investment that is inline with your risk tolerance.

TradeKing Margin Requirements

Obviously it’s important to estimate in advance how much margin interest cost you expect to incur on every margin trade, because you’ll need the interest you receive from your bond to outperform these costs. Margin rates vary from account to account. The greater the amount you borrow, in general, the lower your rate will be. You can view the lower rates as a volume discount.

If you understand the risks, you can buy Treasuries on margin as long as you have a margin account which meets the minimum equity requirement of $2,000. Not all bonds may be purchased on margin. For Treasuries the initial and maintenance margin requirements are usually 10% of the current market value. These requirements could increase due to market volatility, fluctuations in the bond’s value, concentrated positions, trading illiquid bonds and other factors.

If the equity in your account is not sufficient to meet these requirements, you will be required to increase your cash or marginable security holdings to ensure you have sufficient collateral to repay the loan. When this happens, it’s known as a “margin call,” and TradeKing will instruct you to adjust your holdings over the life of the investment.

Tax Ramifications

Investments in Treasuries are taxable at the federal level, but exempt from state and local taxes. Consult your tax advisor for the low-down on this important topic.

TradeKing Tip



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