How to Trade Treasury Bonds

Treasury bonds are US government-issued debt securities, and are widely considered to be one of the lowest-risk investments available. Here’s how you can trade Treasury bonds, and why you might want to do so.

An quick introduction to Bonds

Investors prioritising income or safety during market upheavals often turn to the bond market. Bonds, which are debt instruments, are widely used to hedge against stock market volatility, as the two markets tend to move in opposition to each other. 

As central banks raise interest rates, returns from bonds rise in tandem. They approach a level where they start challenging the returns offered by the stock market. The difference is, between bonds and stocks, the former is seen as risk-free (or at least, lower risk – we’ll see why later), which prompts investors to sell off stocks and buy into bonds instead. This causes downward pressure on stock prices, which exacerbates the rotation to bonds. 

Now that we’ve explained why investors may want to invest in bonds, let’s take a closer look at what are perhaps the most well-regarded bonds of all – Treasury bonds. 

What are Treasury bonds?

Treasury bonds are used by the U.S. government to raise funds for its needs and obligations. You can think of Treasury bonds as a loan agreement between the US government (the borrower) and the investing public (the lender). 

As the borrower, the U.S. government agrees to repay the value of the bond within a stipulated period, as well as a fixed yearly interest; this is known as the coupon. Investors who purchase the bond are known as “bondholders”. As lenders, they are entitled to the terms of the bond, including the coupon. 

What makes bonds attractive? Well, a loan is only good as far as the borrower honours their obligation to repay the loan and the interest promised. Because bonds are routinely offered by credible organisations such as governments, they are widely regarded to be low-risk investments.

Treasury bonds, in particular, are guaranteed by the U.S. government, and no Treasury bond default has ever officially taken place. ^[1] Furthermore, due to the Dollar’s reserve currency status, Treasury bonds are capable of holding their value well through all sorts of economic environments. This is why Treasury bonds are regarded as one of the lowest-risk investments available.

Note that the U.S. is not unique – many other countries also have good track records when it comes to government-issued bonds. However, defaults – known as sovereign defaults – have occurred on occasion throughout history ^[1]. 

How do Treasury bonds work?

Upon issue, Treasury bonds bondholders to collect the stipulated coupon rate until the end of the bond’s tenure. At such time, the entire principal sum of the bond is paid back to the bondholder, along with the final coupon payment, if applicable. 

Bondholders stand to benefit most by holding the bond to maturity, so as to continue receiving the coupon payments. However, bondholders are also allowed to sell their bonds on the secondary market if they so choose. 

While the coupon rate of each Treasury bond is fixed upon issuance, it does not mean that all Treasury bonds offer the same rate of return. Treasury bond rates are impacted by several factors, including central bank interest rates and coupon rates can differ from one tranche to next.

Also, the coupon rate of the Treasury bond may differ from its yield – the latter is impacted as the bond trades on the secondary market. For example, consider a Treasury bond with a 3% coupon rate. If the face value of the bond stays the same, the yield remains equal to the coupon rate at 3%. 

However, if the bond is traded for a lower value, the yield (which is the return as a percentage of the price paid) will increase. 

Here’s a simple example:

• Treasury bond, face value of USD 10,000, coupon rate @ 3% per annum = US D300 
• Sold on market for USD 9,500, coupon rate @ 3% per annum = USD 300 
• Yield = 300/9500 x 100 = 3.157%

Remember, the coupon rate is paid on the face value of the bond (i.e, USD 10,000), and remains fixed throughout the bond’s tenure. Hence, in this case, a Treasury bond with a 3% coupon rate furnishes a yield of 3.157%.

Treasury bill vs note vs bond ^[2]

Treasury bonds aren’t the only U.S. government issued debt securities. There are also Treasury Notes and Treasury Bills on offer. 

The largest difference between these three are their tenures, although there are also some structural differences to note. 

Treasury bills

Treasury bills have the shortest duration among Treasury debt securities. They are offered in tenures lasting four, 13, 26 or 52 weeks. There are also cash management bills which have extremely short durations of just a few days.

Note that Treasury bills do not pay interest, but are instead sold at a discount. The face value of the bill is paid upon maturity, with the difference making up the return on investment.

For instance, you won a Treasury bill with a face value of USD 5,000 by paying a bid of USD 4,750. When the bill matures, you receive the full USD 5,000, earning USD 250 in the process. Thus, the yield on the bill is 250/5000 x 100 = 5%.

Treasury notes

Treasury notes are catered to investors with short- to mid-term timelines. They have maturity periods of two, three, five, seven and 10 years, striking a balance between opportunity risk and return rate. Longer-term notes tend to pay higher coupon rates, but this is dependent on market conditions. 

Treasury bonds

Treasury bonds offer long-term options for those seeking to hold U.S. government debt over a long duration. They are offered in 20-year and 30-year terms, and the coupon rate is paid twice a year. 

Note that Treasury bonds are especially susceptible to interest rate risks, due to their long durations. New bonds with higher coupon rates may be launched, which will cause the value of your original bond to fall.

How to trade Treasury bonds?

You can trade bonds, notes and bills in three ways. 

1. Direct purchase from TreasuryDirect or online brokerage ^[3]

If you are an eligible U.S. citizen, you can open an account on TreasuryDirect – an online marketplace run by the U.S. Treasury Department – to participate in Treasury auctions. This is a low-cost and convenient way to invest in Treasury bonds for those who qualify for an account. 

Alternatively, you can search for an online brokerage that offers access to Treasury auctions, and make your bids via proxy. Note that some brokerages may charge extra fees for this feature, and may also have settlement processes that differ from TreasuryDirect. 

2. Buying and selling on the secondary bond market ^[4]

As explained, Treasury bonds need not be held to maturity, and may be traded on the open market. This has given rise to the bond market, which investors can access via an online brokerage. 

Trading Treasury bonds on the secondary market will come with sales commissions and fees – these vary according to the brokerage you use. 

3. Trading bond Contracts-for-Difference (CFD)

Treasury bonds and other debt securities can also be traded without taking direct possession of them. This is made possible with bond CFDs, which allow you to seize trading opportunities on the price movements of the underlying bonds and reap potential returns. 

Note that investing through bond CFDs does not entitle you to the coupon payments; only the actual bondholders will receive them.

Trade Treasury bonds with Vantage CFDs

Trade highly-rated U.S. and EU bonds with Vantage CFDs. Start investing in popular bonds at a fraction of actual bond prices, and enhance your position with up to 5x leverage. Reduce risk by starting as small as one lot size, and trade both long and short positions to potentially benefit from all market conditions. Sign up today!

References