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Bond Categories

Terminology

Inflation

Inflation results from an increase in the supply of money which has the effect of increasing demand for the goods and services businesses provide. This in turn allows these businesses to this increase their prices to the extent where consumers are still willing to pay these higher prices.

Limit Order

An order to buy shares at a price that is less than the best Ask price or an order to sell shares at a price that is more than the best Bid price. A Limit Order will only be filled if the stock price reaches the limit order price.

Market Order

A Market Order is a trade order to either buy stock at the best Ask price or to sell stock at the best Bid price. The market Order will be filled almost immediately.

Treasury Bonds

Safety with Treasuries - as good as guaranteed

Bond Categories - Treasury Bonds; picture of United States of America money with one hundred dollar bills in large sheet printed out from a government money printing machine

The U.S. Federal Treasury issues bonds with various maturities ranging from four weeks up to 30 years. Treasury bonds come with the full faith and credit of the U.S. government which effectively makes them a guaranteed investment.

Note that this does not mean they are actually guaranteed, but that the U.S. government will endeavor to meet its obligations even if it has to increase taxes, print more money etc. Basically they are as good as guaranteed and are the safest bonds compared to municipal bonds and especially corporate bonds.

In addition to their safety, treasury bonds are not callable, thus a Treasury bond holder will continue to receive their coupon payments until maturity with no risk of early recall. Also treasury bonds are extremely liquid which gives them tight spreads compared to other bond types which is a bonus should the investor decide to buy and sell treasury bonds.

The difference between Bills, Notes and Bonds

The difference between treasury bonds, notes and bills is mostly the term till maturity. All maturities have a minimum face value of $100 and can be bought in increments of $100. They are all issued in electronic form and each bond is registered with a serial number.

  • Treasury Bills are issued with maturities of 4, 13, 26 and 52 weeks and are bought at a discount to the face value (the interest is the difference between the amount paid and the face value).
  • Treasury Notes are issued with maturities 2, 3, 5, 7 and 10 years and pays interest every 6 months.
  • Treasury Bonds are issued with a maturity of 30 years and pays interest every 6 months.

The actual price paid for newly issued treasury bills, notes and bonds is determined by an auction process. This means that the price paid is not necessarily the face value. Each investor has a choice of whether to accept the market rate or whether to set a limit on how much to pay. This is analogous to placing a market order to buy stocks or placing a limit order. A market order will ensure the purchase whereas a limit order may not be filled.

Newly issued treasury bills, notes and bonds can be purchased directly from the U.S. Treasury through their website treasurydirect.gov. Unfortunately only market orders are accepted when buying through their website. In order to place a limit bid, investors must use a bank, broker or dealer as only they can place competitive bids. This is similar to buying stocks where a broker is required to place a limit buy order.

Treasury Inflation-Protected Securities (TIPS)

One of the disadvantages with bonds, especially long-term bonds is that inflation can become higher than the bond yield. To offset the effect of inflation, the U.S. Treasury also issues a bond which is adjusted for inflation and they are referred to as Treasury Inflation-Protected Securities (TIPS).

Investors can purchase inflation protected bonds

but the yields are generally lower

The advantage with TIPS is that the principle returned at maturity is increased based on the Consumer Price Index (CPI). If inflation happened to be negative, then the investor simple receives the face value. Thus the principle is only adjusted upwards and not downwards. The disadvantage with TIPS is that the coupon rate is relatively low, thus investors seeking income will receive a lower coupon payment with TIPS.

While TIPS at first sound like a good idea, the U.S. Treasury takes into account the likely future inflation rates and factors this into the TIPS yield. Sometimes the investor will receive a better return with TIPS held to maturity and at other times the return from TIPS will be less than if bonds were held till maturity.

TIPS are bought in exactly the same manner as with treasury bonds and are issued with maturities of 5, 10 and 30 years and sold in increments of $100 with a minimum purchase of $100.

Some professional bond investors suggest that retail investors incorporate a mix of bonds and TIPS which helps smooth out the returns as inflation has a tendency to cycle through periods of high inflation and periods of low inflation.

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