The Risks of Treasury Notes and Bonds

Since Treasuries are an direct obligation of the federal government, these do not possess a credit risk or default risk. The Treasures issued after the year 1985 are free of event risk and call risk, but are subject to interest rate risk and inflation risk. Avoid long-term maturity unless you trust in the inflation rates and the interest in the market will lower.

Treasury inflation-protection securities
Treasury inflation-protection securities (TIPS) are securities issued by the Treasury whose interest and principal payments are adjusted for changes in inflation. Because inflation has been low historically in the early years of this decade, these bonds have not generated much enthusiasm.

The TIPS are issued with a fixed coupon rate plus an amount that is indexed by inflation. The coupon rate is determined in auction and kept fixed during the term of the security. The principal amount of the security is adjusted to inflation, but this inflation-protection premium is paid only at maturity. For example, if you buy a bond with a 3 ?% coupon rate at $1000 and there is an average inflation of 2% for the year, the price of the bond is adjusted by inflation at $1020. The 3 ? % coupon rate was paid over the bonds adjusted value (3 ?% x $1020). The opposite occurs if inflation falls. The price of the bond is adjusted downward and the interest payments are estimated against the lower price of the bond. Six-month payments of interests are based on the adjustment by inflation of the principal amount of the bond at the time of disbursement of said interests.

Yields on Treasury inflation-indexed securities generally are lower than those on regular bonds during periods of low inflation before investing. For example, if a Treasury bond at 10 years is yielding a 4.875% and 10-year inflation-indexed bond is yielding 4.25% in order to exceed the regular Treasury bond, inflation will have to increase by more than 0.625% (4.875% - 4.25%) over the next 10 years.

The auction process uses an single price, or Dutch method of auction for these securities. The securities are eligible fro stripping into principal and interest components in the Treasury’s separate trading of registered interest and principal of securities (STRIPS) program.

At maturity, TIPS are redeemed at the greater of their inflation-adjusted principal or par value. The negative part of an inflation-indexed Treasury is that the bearers must pay taxes over their tax incomes plus inflation adjustment, even when the adjustment because of inflation are paid only at bonds maturity.

In other words, a negative cash flow is created due to the “ghost” income adjustment, which makes this type of investments to be more according with a tax-deferred account.

As other types of Treasury securities, incomes for interests are exempt from local and state taxes. You can buy these issues in the same way as in a regular buy of Treasury notes and bonds.

Since this is a new type of security you don’t have many issues from where to choose in the secondary markets. This type of security as all with fixed incomes are subject to risks in interest rates. Yields in this type of securities are much less than regular Treasury issues, and if inflation remains low, any type of change in the interest rates will make prices of these securities be more volatile, specially for those issues that have maturities on longer-term periods. However, this type of security protects you against damages because of inflation. But, on the contrary, if inflation remains low, TIPS holders receive lower returns than the ones they could receive with regular Treasury notes and bonds for the same maturity period.