US Government Bond Products
What are “US Government Bonds Products”?
The US government bonds products include treasury bills, treasury notes, treasury bonds, and TIPS (Treasury Inflation Protected Securities), and are generally considered the safest of all investments. These bond products are a very important source of funding for the US government, in addition to other sources (primarily taxes). The US government issues these bonds products to investors, including individuals, corporates and asset managers, and anyone else interested in purchasing these bonds. In return, the government receives cash from these investors. By issuing bonds products, the US government receives money to finance its ongoing budget.
Essentially, when an investor purchases a US government bond product, it is lending money to the federal government for a specified period of time.
Key Learning Points
- The four types of US government bonds products are: treasury bills, treasury notes, treasury bonds, and TIPS
- The maturities of the same range from less than 52 weeks to 30 years
- US government bonds, like other bonds, are priced using the present value (PV) formula
Types of US Government Bonds – Products
Treasury Bills: are short-term securities where maturity can range from a few days to less than 52 weeks. Instead of paying a fixed interest rate, T-bills are sold at a discount to their face value. Therefore, the face value is usually higher than the original purchase price. As these treasury bills mature, the investor is paid the full face value.
Treasury Notes: are medium-term securities that can last between 2 and 10 years. They pay a fixed interest rate or coupon every six months. The notional amount of the bond is returned on maturity.
Treasury Bonds: are long-term securities that have a maturity range of 10 to 30 years. They pay a fixed interest rate or coupon every six months. The notional amount of the bond is returned at maturity.
Treasury Inflation Protected Securities (TIPS): are US government bond products that are indexed to inflation, so that investors are protected against the fall in their purchasing power due to inflation. If there is a rise in inflation, TIPS adjusts in price to maintain its real value.
US Government Bond Products – Pricing
The formula for pricing US government bonds products, as other bonds, is stated below:
PV = FV/(1+r) ^n
PV = Present value i.e. price or value of bond
FV = Future Value of the bond
r = interest rate or desired rate of return, per period
N = Number of periods to maturity
C = Coupon amount
Of course, if a US government bond has a coupon, we have to take the present value of the coupon amount into consideration as well i.e.
Coupon Bond Price = (C1/(1+r)^1 + C2/(1+r)^2 + C2 +FVn)/(1+r)^n
US Government Bond Products – Example
Assume that an investor’s desired rate of return (i.e. r) is 9%. Given below is an example of a zero coupon bond. Now, we wish to know how much this investor should pay today, to purchase this US government bond product which has a face value of $1,000 and matures in 7.5 years (i.e. n). This bond pays no coupons during its lifetime, therefore we do not need to be concerned about including coupon payments. We just need to focus on the face value and the present value of the bond.
So, we calculate the present value of this zero coupon US government bond, using the above-mentioned formula. The present value (PV) is $524. This is the maximum that this investor could pay, in order to get a 9% return on this zero coupon bond.
Remember, in some bonds, the face value is higher than the original purchase price, which is the case here.
Next, is an example of the pricing of a US government bond product that pays a coupon. This investor’s desired rate of return remains 9%. We want to know how much this investor should pay for a bond with a face value of $1,000 that pays an 8.5% annual coupon and matures in 6 years.
Before calculating the present value of this bond, we need to calculate the payments (pmt), which are the coupons that are getting paid once a year for 6 years (which is 8.5% multiplied by the face value of the bond). The payment is $85 per bond per year.
Next, we take all this information (given below) to calculate the present value, which is $977.60, which is the most that an investor could pay for this bond.