Treasury Bills, Notes, and Bonds: How US Debt Works

Key Takeaways

• T-bills pay no coupon and are issued at a discount; notes and bonds pay semiannual coupons.
• Treasury auctions use a single-price (Dutch) format where all winners pay the stop-out yield.
• Treasury interest is exempt from state and local income tax but subject to federal tax.
• Longer maturities carry no credit risk but significant interest-rate risk; a 30-year bond can lose 20% in a rate spike.

What It Is

The Treasury issues several types of marketable securities. The three core ones are differentiated by how long they run before repaying principal.

• Treasury bills (T-bills) mature in 4, 8, 13, 17, 26, or 52 weeks. They pay no coupon. You buy them at a discount to face value and receive face value at maturity. The difference is your interest.
• Treasury notes (T-notes) mature in 2, 3, 5, 7, or 10 years. They pay a fixed coupon every six months and return principal at maturity.
• Treasury bonds (T-bonds) mature in 20 or 30 years. Structurally they work like notes, just longer-dated.

All three are backed by the full faith and credit of the US government. Two other marketable types, Treasury Inflation-Protected Securities (TIPS) and Floating Rate Notes (FRNs), round out the marketable set.

The Intuition

Every Treasury is a loan from investors to the US government. The auction process determines the rate on each new issue. Once issued, the securities trade in a deep secondary market run by a network of primary dealers, where prices move continuously with macro data, Fed expectations, and global demand.

Because default risk is treated as effectively zero by most market participants, Treasury yields isolate pure interest-rate risk. The Treasury yield curve, the plot of yield versus maturity across all these securities, is the single most watched dataset in fixed income. Every corporate, municipal, and mortgage bond in the US trades at a spread over a Treasury of similar maturity.

The split into three labels is partly a reflection of how different buyers use them. Money-market funds, corporate treasurers, and foreign central banks live at the bill end. Banks and pension funds own notes to match medium-term liabilities. Life insurers and long-duration liability managers reach for bonds. The Treasury calibrates issuance across the curve so that it can fund the deficit without overloading any one maturity.

How It Works

The Treasury sells bills, notes, bonds, TIPS, and FRNs through regular public auctions. The auction process runs in three stages: announcement, bidding, and issue.

At announcement, the Treasury publishes the amount to be sold and the maturity date. Bidders can submit two types of bids:

• Competitive bids specify the yield the bidder is willing to accept. Primary dealers and institutions use these.
• Non-competitive bids accept whatever yield comes out of the auction. Retail investors on TreasuryDirect use these, capped at $5 million per auction per bidder.

The Treasury fills all non-competitive bids first, then allocates the remaining amount to competitive bidders starting from the lowest yield until the issue size is filled. The highest accepted yield, called the high yield or stop-out yield, becomes the rate paid on the entire issue. This is a single-price (Dutch) auction design.

T-bills are quoted on a discount yield basis:

Discount Yield = ((Face Value - Purchase Price) / Face Value) x (360 / Days to Maturity)

Notes and bonds are quoted as a price per 100 of face value, with semiannual coupons. A quote of "99-16" means 99 plus 16/32, or 99.50. The yield to maturity falls out of the price given the coupon and time to maturity.

Auction frequency varies. Short bills are auctioned weekly. 2-, 3-, 5-, and 7-year notes are monthly. The 10-year note and 30-year bond are auctioned monthly as new issues or reopenings. TreasuryDirect publishes a tentative schedule each quarter.

Worked Example

A 26-week Treasury bill with 182 days to maturity is auctioned at a price of 98.00 per 100 of face value. The investor buys $10,000 face for $9,800.

Discount Yield = ((100 - 98) / 100) x (360 / 182)
               = 0.02 x 1.978
               = 0.03956  (or 3.96 percent)

On an investment yield basis, which uses actual days and the purchase price as denominator, the return is slightly higher:

Investment Yield = ((100 - 98) / 98) x (365 / 182)
                 = 0.02041 x 2.005
                 = 0.04094  (or 4.09 percent)

The two conventions answer slightly different questions. Always check which basis is being quoted before comparing across products.

Common Mistakes

1. Confusing discount yield with yield to maturity. Bill yields on the secondary market are often quoted as discount yields, while notes and bonds are quoted as yields to maturity. The numbers are not directly comparable; convert to a common basis before making decisions.

2. Assuming "risk-free" means zero price risk. Treasuries have no credit risk, but their prices still move. A 30-year bond can lose 20 percent of its value in a sharp rate-hike cycle. Default-free does not mean price-stable.

3. Confusing the auction's "high yield" with a headline interest rate. The stop-out yield is specific to that auction and reflects demand on that day. It can differ from the secondary market yield quoted on data services because of when-issued trading and bid-ask dynamics.

4. Mixing up when-issued and settled securities. Between announcement and issue, a Treasury trades on a when-issued basis. Prices during that window reflect expectations of the auction result and are not the same as the settled security.

5. Forgetting state tax exemption. Interest on Treasuries is taxable at the federal level but exempt from state and local income tax. For an investor in a high-tax state, that exemption can make Treasuries more attractive than their headline yield suggests compared to corporate bonds.

Frequently Asked Questions

Can individual investors buy Treasuries directly, and how? Yes. TreasuryDirect allows US residents to purchase new-issue Treasuries directly from the Treasury at auction using non-competitive bids. Investors pay the auction clearing rate with no broker fees. TreasuryDirect also allows holding securities to maturity and automatic reinvestment, though selling before maturity requires transfer to a broker account.

Why do T-bill yields sometimes exceed note or bond yields? Inverted yield curves occur when short-term rates are pushed above long-term rates, typically by Federal Reserve tightening. Markets price in future rate cuts, pulling long yields lower while current short rates remain elevated. This condition often precedes recessions and is closely watched as a leading indicator by economists and investors.

What is a Treasury reopening, and does it trade differently from a new issue? A reopening increases the outstanding supply of an existing Treasury that was issued earlier, with the same coupon and maturity date, rather than issuing a brand-new security. Reopened bonds are fungible with the original and trade identically. The Treasury uses reopenings to build larger, more liquid benchmark issues rather than fragmenting the market with many small securities.

How does the primary dealer system work in Treasury auctions? Primary dealers are financial institutions approved by the Federal Reserve Bank of New York to trade directly with the Fed and participate in Treasury auctions. They are required to bid at every auction and to make markets in Treasuries in the secondary market. The dealer network ensures the Treasury can sell its entire offering at each auction even without retail demand.

Are Treasury bonds safe during a financial crisis? Credit risk remains near zero. However, during certain acute crises, such as March 2020, even Treasury prices briefly dislocated as dealers were overwhelmed by selling and the bid-ask spread widened significantly. The Fed intervened by purchasing Treasuries outright. Treasuries are safe from default but not from short-term liquidity squeezes in extreme market stress.

Sources

1. TreasuryDirect. "About Auctions." https://www.treasurydirect.gov/auctions/
2. TreasuryDirect. "Treasury Notes." https://www.treasurydirect.gov/marketable-securities/treasury-notes/
3. TreasuryDirect. "Treasury Bills." https://www.treasurydirect.gov/marketable-securities/treasury-bills/
4. TreasuryDirect. "Treasury Bonds." https://www.treasurydirect.gov/marketable-securities/treasury-bonds/
5. TreasuryDirect. "Understanding Pricing and Interest Rates." https://treasurydirect.gov/marketable-securities/understanding-pricing/

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.