What it means
The mechanics are simple: the government sets a coupon rate at issue, and the holder receives that percentage of the face value every year, split into two payments, until maturity. A $500,000 holding of a 4% bond pays $10,000 every six months regardless of what happens to market rates in between.
What changes is the price. If market interest rates rise after issue, a bond locked at the old, lower coupon becomes less attractive, so its price falls until its yield matches what a new buyer could get elsewhere, and the reverse happens when rates fall.
Treasury bonds matter to businesses even when they never buy one. The yield on long dated government bonds is the base for discount rates used in valuations, pension liability measurement and lease accounting, so a movement in that yield quietly changes the numbers throughout a company's accounts.
Duration is the measure that captures price sensitivity, expressing roughly how much a bond's price moves for each 1% change in yield. A thirty year bond has far more duration than a two year note, which is why long bonds are the volatile end of a supposedly safe asset class.
The important nuance is that safety refers to credit, not to price. A treasury bond will almost certainly repay in full at maturity, but an investor forced to sell in the middle of a rate rising cycle can suffer a substantial loss, and holding one for thirty years exposes the return to decades of inflation.
In practice
Real-world examples.
Example
A defined benefit pension scheme buys thirty year treasury bonds to match payments it expects to make to retirees decades from now. Because the cash flows line up, a fall in bond yields raises both the value of the assets and the value of the liabilities, keeping the funding position broadly stable.
Example
A corporate treasurer valuing a proposed acquisition uses the long treasury yield as the risk free base in the discount rate. When that yield rises by 1%, the discounted value of the target's future cash flows falls enough to cut the justifiable purchase price by several million dollars.
Example
A family office that bought long bonds when yields were very low sees the market value of the holding fall by more than a fifth after a sharp rate rise. Because it intends to hold to maturity, it still receives every coupon and the full face value, but the interim loss shows up in its reported net worth.
Think of it
“Treasury bond is long-term US government debt-10 to 30 year maturities.
Formula
Calculation
Annual coupon = face value x coupon rate
Current yield = annual coupon / market price
An insurance company buys $500,000 of face value in a thirty year treasury bond with a 4% coupon, at a price of 95, meaning 95% of face value. The purchase cost is $500,000 x 0.95 = $475,000.
The annual coupon is $500,000 x 4% = $20,000, paid as two instalments of $10,000. The current yield is $20,000 / $475,000 = 4.21%, higher than the 4% coupon rate because the bond was bought below face value, and the holder will also receive the extra $25,000 of face value at maturity.Case study
Seen in the real world.
This is an illustrative, fictional example. Meridian Mutual Assurance, an invented life insurer, held a large book of long dated treasury bonds bought during a period of unusually low yields, and its investment committee described the portfolio as its safe allocation.
When long yields rose by around two percentage points over eighteen months, the market value of that portfolio fell sharply and the insurer's regulatory capital ratio came under pressure, even though not a single coupon payment had been missed. The problem was not credit at all, it was duration, and nobody in the committee had been reporting duration as a headline number.
The fictional response was to publish portfolio duration alongside yield in every quarterly pack, and to shorten the average maturity of the newly invested money so that maturing bonds could be reinvested at the higher prevailing rates. The book value loss remained until the bonds matured, but the exposure to another rate shock was materially reduced.
Watch out
Common mistakes.
- Treating treasury bonds as free of all risk, when interest rate risk and inflation risk can both produce large losses in real terms.
- Comparing the coupon rate with a savings rate and ignoring the price paid, since a bond bought above or below face value yields something quite different from its coupon.
- Assuming a bond fund behaves like an individual bond, when a fund never matures and so never guarantees the return of a fixed amount on a fixed date.
Questions
People also ask.
What is the difference between a treasury bond and a treasury note?
Length, essentially, with notes typically running two to ten years and bonds twenty years or more, though both pay semi-annual coupons.
Why do bond prices fall when interest rates rise?
Because a fixed coupon becomes less attractive next to newly issued bonds paying more, so the price adjusts downward until the yields match.
Should a small business ever hold treasury bonds?
Rarely for surplus cash, because the price volatility of a long bond is unsuitable for money that may be needed within a few years.
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