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Tuesday, March 24, 2009

US Treasuries are Uncle Sam's IOU: How they work

Treasuries are Uncle Sam's IOU: A United States Treasury security is really just an IOU from the government. You lend Uncle Sam some money, and he promises to pay you back, plus interest. To be more formal, a Treasury security is government debt issued by the United States Department of the Treasury through the Bureau of the Public Debt.

Treasury securities are the debt financing instruments of the United States Federal government. You know our federal government can spend some money big time And somebody is paying for all of these stimulus packages. Sure, us taxpayers contribute up a lot. But our government is running some big time deficits. Not to mention the “off the book” stuff like social security. So, our government needs to borrow even more money and to do that, it sells Treasuries. (Securities issued by other Federal agencies accounts for the rest of the Federal debt).

Pretty much anyone can purchase Treasuries. You, me, funds, institutions, foreign governments. Foreign governments own a lot of our country’s debt. The top 10 are China, Japan, the United Kingdom, Caribbean banking nations, certain oil exporting nations, Brazil, Russia, Luxembourg, Hong Kong and Switzerland. I know what you are thinking, it is kind of a strange concept, but nobody in Washington seems to be complaining.

There are four types of marketable treasury securities: Treasury bills, Treasury notes, Treasury bonds, and Treasury Inflation Protected Securities (TIPS). There are several types of non-marketable treasury securities including State and Local Government Series (SLGS), Government Account Series debt issued to government-managed trust funds, and savings bonds. All of the marketable Treasury securities are very liquid and are heavily traded on the secondary market. The non-marketable securities (such as savings bonds) are issued to subscribers and cannot be transferred through market sales.

Treasuries are considered the "safest" investment there is. Why? Because the government is the only entity that has a legal printing press to print more money to pay back its debt. Of course, others would argue gold is a safer investment because it has intrinsic value as a precious metal, but that is also topic for another day. Let’s take a quick look at Treasuries.

Treasury Bills

Treasury bills, or T-bills, are sold in terms ranging from a few days to 52 weeks. Bills are typically sold at a discount from the par amount (also called face value). For instance, you might pay $990 for a $1,000 bill. When the bill matures, you would be paid $1,000. The difference between the purchase price and face value is interest. You can buy a bill in TreasuryDirect or Legacy Treasury Direct, or through a bank, broker, or dealer. Bills are sold in increments of $100 and the minimum purchase is $100. All bills except 52-week bills and cash management bills are auctioned every week. The 52-week bill is auctioned every four weeks. Bills are issued in electronic form. You can hold a bill until it matures or sell it before it matures. For Treasury Bills, Notes and Bonds, an investor can buy up to $5 million by non-competitive bidding or up to 35% of the initial offering amount by competitive bidding. To learn more, or to open an account with Treasury Direct, go to this url:
Treasury Notes

Treasury notes, or T-notes, are issued in terms of 2, 3, 5, 7, and 10 years, and pay interest every six months until they mature. The price and interest rate of a Note are determined at auction.

Treasury Bonds

Treasury bonds are issued in terms of 30 years and pay interest every six months until they mature. When a Treasury bond matures, you are paid its face value. The yield on a bond is determined at auction. Bonds exist in either of two formats: as paper certificates (these are older bonds) or as electronic entries in accounts. Today, the Treasury issues bonds in electronic form, not paper but paper bonds can be converted to electronic form.

Savings EE Bonds

Series EE Bonds are reliable, low-risk government-backed savings products that you can use for retirement income, as well as gifts such as for children and grandchildren and financing education. Series EE Bonds purchased on or after May 1, 2005, earn a fixed rate of return, letting you know what the bonds are worth at all times You can purchase EE Bonds electronically over the Internet at www.TreasuryDirect.gov or you can purchase paper EE bonds at banks and other financial institutions. If you redeem EE Bonds in the first 5 years, you’ll forfeit the 3 most recent months’ interest, but if you redeem them after 5 years, you won’t be penalized.

Treasury Inflation-Protected Securities

TIPS, or Treasury Inflation-Protected Securities, are securities whose principal is tied to the Consumer Price Index. With inflation, the principal increases. With deflation, it decreases. Interest is paid every six months, based on a fixed rate applied to the adjusted principal. At maturity, TIPS pay the original or adjusted principal, whichever is greater. TIPS are sold in terms of 5, 10, and 20 years.

I Bonds

The Treasury’s inflation-indexed I bonds are designed to offer all Americans a way to save that protects the purchasing power of their investment by assuring them a real rate of return above inflation. I bonds have features that make them attractive to many investors. They are sold in electronic form in amounts of $25 and above, or in paper form at face value in denominations of $50, $75, $100, $200, $500, $1,000, $5,000, and $10,000, and earn interest for as long as 30 years. I bond earnings are added every month and interest is compounded semiannually. They are state and local income tax exempt, and the federal income tax on I bond earnings can be deferred until the bonds are cashed or they stop earning interest after 30 years. Investors cashing I bonds before five years are subject to a 3-month earnings penalty. Savers and investors can now open an on-line account to purchase I bonds in electronic form, as well as EE savings bonds and Treasury marketable securities, through the website www.TreasuryDirect.gov. Account holders can purchase, manage, and redeem such I bonds over the Internet 24 hours a day, seven days a week.

* * *

Ok, so that’s the basic on Treasuries. Now, as noted earlier, China owns a bunch of our Treasuries, to the tune of about $1 trillion. China surpassed Japan last year as the largest foreign holder of Treasury bonds. In fact, they have over half of their foreign currency invested in our debt so you can imagine that they want to make sure their investments will pay off.

This weekend, China’s Premier Wen Jiabo acknowledged that China was worried about having all of this money in U.S. Treasury Bonds. Specifically, Premier Jiabo said, "Of course we are concerned about the safety of our assets. To be honest, I'm a bit worried. I would like to call on the United States to honor its words, stay a credible nation and ensure the safety of Chinese assets."

China is worried that the dollar is going to depreciate because of the excess spending on the part of Uncle Sam. But China is kind of in a bind as well. After all, where are they going to put all that money? The Financial Times is reporting that a director-general at the China Banking Regulatory Commission had this to say on the topic:

“Except for US Treasuries, what can you hold? Gold? You don’t hold Japanese government bonds or UK bonds. US Treasuries are the safe haven. For everyone, including China, it is the only option. We hate you guys. Once you start issuing $1 trillion - $2 trillion...we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.”

Hmm, you have to at least appreciate his frankness, if not his sentiment. More on that at the following url:
The comments by China’s premier are important for several reasons. We know the United States has embarked on a spending spree the likes of which our country has never seen. The Federal Reserve, the Treasury, the White House and most of Congress have adopted the view that we must spend now to avoid a deepening recession. The hope is that the economy will start back up, tax revenues will start coming in again, employment will rise, and THEN, we will be in a better position to start paying down our debt. It’s a plan, that’s for sure. Whether it is a realistic one, I don’t presume to be any smarter than the top dogs at the Fed or at the Whitehouse, nor do I have a crystal ball.

My personal belief, however, is that the economy will recover as the spending works its way through the system, and the Fed’s efforts take hold. However, I think we will face another crises shortly thereafter. There are unfunded promises made for Social Security, Medicare and federal retirement programs that account for a significant portion of taxpayer liabilities. And neither the Republicans nor the Democrats have really been willing to curb government spending when in power so to expect either party to change too much seems to be unrealistic.

Not to digress too far, but the yields on Treasury Bills, Notes and Bonds right now are extremely low. At some point, if foreign governments like China decide to curb back their investments in our government’s debt, then the interest we pay on our debt will have to be higher to attract new investors. Either that, or the government could allow or force a debasement of the dollar so that the debt could be purchased at what is really a discount since foreign investments into Treasuries must be made with dollars.

The other side to this equation is inflation. Right now, inflation is basically zero (as reported by the government) and the bigger worry from the Fed is deflation. But down the road, I am of the opinion we will get inflation of some sorts, and if you are locked in on a long-term Treasury bond and yields are rising, you are not going to be happy. If it is a date-certain bond that you hold to maturity, you will get your money back. But the purchasing power of your money is going to be eroded by inflation. If you are in a bond fund with long-term maturities and yields start rising, the net asset value should decline and that is also not an ideal situation if you own the fund.

Right now, Treasuries are reflecting a world that is paying a premium to avoid risk. But that will change as the pendulum swings again.


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