Treasury bonds vs. bills vs. notes: Understanding the differences in government-backed securities

U.S. Treasury securities, often considered a safer alternative to stocks, are an important part of many investment portfolios. These securities—a type of debt instrument used by the U.S. Treasury to fund expenditures—come in several forms. If you're about to purchase government debt for the first time, it can be confusing.

Let's break down the main features of the different types of federally issued securities. Once you understand the distinction between Treasury bonds vs. bills vs. notes, you'll be able to make informed decisions about how to incorporate them into your investment strategy.

T-bills, T-notes and T-bonds all represent marketable securities from the U.S. Treasury that essentially take the form of an IOU. When you buy these securities, the government is making a promise to pay you back, with interest, at a later date. Because Treasury securities are backed by the full faith and credit of the federal government, there's very little risk you won't get your principal back at maturity. And all three securities have a high level of liquidity, enabling you to easily buy or sell them when you want to make changes to your portfolio.

Despite their important similarities, however, these three types of Treasuries differ in several important ways, including when they mature and the rate of return they offer.

Treasury bills are short-term securities issued in four different maturity periods: four weeks (one month), 12 weeks (three months), 26 weeks (six months) and 52 weeks (one year). Unlike most government securities, T-bills don't actually pay interest to the investor. For that reason, they're referred to as "zero coupon" bonds. You buy the bill at a discount to its face (or "par") value.

For example, you might buy a 52-week Treasury bill with a face value of $1,000 for $970. When the bill matures, however, you receive the full $1,000. The difference between the purchase price and the face value represents the interest you have earned. In this example, you would receive a 3.1% annual return on your investment.

The sale price of a T-bill depends on market conditions as well as Federal Reserve policies. When interest rates are relatively high, you can buy Treasury bills at a steeper discount. Conversely, when rates lower, you have to pay an amount that's closer to the par value.

In general, the shorter the maturity date on a debt security, the lower the amount of interest rate risk—the chance that newly issued securities will offer a higher return. Because they're seen as the safest of the three Treasuries, however, bills typically have the lowest yield.

Treasury notes are medium-term debt securities with maturities ranging from two years to 10 years. Unlike T-bills, T-notes provide a semiannual interest payment, at a fixed interest rate, to the investor.

Because market conditions may change after they are issued, Treasury notes often are sold at a discount (below face value) or at a premium (above face value). As a result, your total return may differ from the fixed coupon rate. When you buy a note at a premium, for instance, you'll have a lower yield than the coupon rate.

With their longer maturity period, T-notes carry more interest rate risk than T-bills, but less than T-bonds. As a result, the former usually offer a rate of return that's somewhere in between the other two versions.

Treasury bonds are the most long-term of the Treasuries, with a maturity of 20 or 30 years. Like T-notes, T-bonds offer a fixed semiannual interest payment from the government and can be purchased at a discount or premium to par value.

The longer maturity dates expose T-bonds to more interest rate risk than other Treasury securities. To compensate the investor, they offer higher yields than T-bills or T-notes.

You can sell any Treasury security before it reaches maturity, although this feature is particularly important for T-bonds because of their long-term nature. The price you'll receive depends on prevailing interest rates at the time.

Bond prices tend to fall when interest rates rise, and vice versa. For example, if you want to sell a 30-year Treasury bond with a 5% coupon, and interest rates for new ones have gone up to 8%, you'll have to offer a low enough discount on the security that it offers an 8% yield. The amount of the discount is considered a capital loss.

The opposite also is true. If interest rates have since fallen to 4%, you can sell the T-bond at a premium, resulting in a capital gain.

Treasury securities offer a high level of safety and liquidity, making them a potential option if you want steady, predictable returns. However, you always carefully should assess the advantages and disadvantages of a particular security before adding it to your investment portfolio.

Pros

• A short duration means there's a smaller risk of interest rates increasing and lowering the value of the security.
• The interest from T-bills and other Treasuries is exempt from state and local taxes, which can be helpful if you live in a high-tax state.

Cons

• Compared to corporate bonds with a similar maturity, Treasury bills offer a smaller rate of return or yield.
• They require frequent reinvestment, potentially at lower interest rates, if you want to stay in the market.

Pros

• Medium-term securities like T-notes provide a middle ground between the low interest rate risk of T-bills and the higher returns of T-bonds.
• The semiannual coupon offers a predictable income stream, which can be particularly beneficial for retirees.

Cons

• Treasury notes tend to offer lower rates of return than more volatile vehicles like stocks.
• A longer maturity means the notes can lose value when interest rates increase.

Pros

• You receive a higher rate of interest than you would with a short-term security, which is a key difference between Treasury bills and bonds.
• The interest payments provide a steady source of income for as long as you hold the T-bond.

Cons

• Treasury bonds can lose value if interest rates go up.
• The fixed coupon payments don't always keep pace with inflation, which can erode your purchasing power over a time.
  

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In general, Treasuries are a good choice if you're a risk-averse investor and want the peace of mind that comes with a government-backed security. If, on the other hand, you can tolerate a bit more risk in exchange for potential better returns, corporate bonds and other dividend-paying stocks may be a better option.

The choice of which Treasuries to buy depends on your personal investment goals. Because shorter maturities translate into lower interest rate risk, T-bills are typically a good fit if you're trying to protect your principal from market volatility. They also can be a good choice if you need access to that money within a matter of weeks or months.

T-notes tend to be a good pick if you have medium-term financial needs and seek a slightly higher yield than T-notes. T-bonds provide a higher yield, although you expose yourself to more interest rate risk due to their longer maturity.

You even may consider a "laddering" strategy that takes advantage of the best features of each type. A typical ladder might include several Treasuries with maturity dates that are three to five years apart, giving you liquidity for short-term expenses but also exposure to longer-term securities that offer higher yields.

You can purchase Treasury bills, notes and bonds directly from the U.S. Treasury, through a bank or brokerage or indirectly through mutual funds that hold them.

You can buy Treasuries directly from the government. Simply set up an account on TreasuryDirect.gov. Once you're logged in, you can select the maturity of the security you'd like to purchase and your desired purchase amount. When you buy from the Treasury Department's online portal, you're making a noncompetitive bid, which means you're accepting the price that security goes for at the Treasury auction.

Rather than going directly through the Treasury's website, you can purchase T-bills, T-notes and T-bonds from a brokerage, a dealer or a financial institution such as a credit union or bank. You either can bid noncompetitively (as you would from the government's portal), or you can bid competitively. When you place a competitive bid, you specify the discount rate and yield you're willing to accept. Depending on the auction results, you may or may not be able to purchase securities that meet your requirements.

Instead of buying individual Treasury securities, you can invest in T-bonds indirectly by purchasing shares of certain bond mutual funds. Unlike individual bonds, bond funds don't have a fixed maturity date. Instead, they offer exposure to multiple debt securities with different maturities. While funds provide diversification, you should research the average maturity of the government securities in the fund to make sure it aligns with your investment goals.

Treasury securities can play an important role in your financial plan, especially if you're looking to balance more volatile investments like stocks. A Thrivent financial advisor can help explain the distinctions between Treasury bonds vs. bills vs. notes and offer personalized guidance on how they might fit into your portfolio.