Invest In Treasuries Etf: A Secure Investment Strategy

Treasury exchange-traded funds (ETFs) are a great way to gain exposure to the U.S. government bond market. They are a welcome addition to the range of funds that investors can use to build a portfolio. Treasuries can be bought in several ways, including through Treasury bills, notes, bonds, Floating Rate Notes (FRNs), and Treasury Inflation-Protected Securities (TIPS). ETFs are bought and sold like stocks, and many qualify for commission-free trades. They are also highly liquid, making them a good option for investors looking for stability and risk management.

Treasury ETFs vs. individual bonds

Treasury ETFs

Treasury ETFs are a great way for risk-averse investors to diversify their portfolio. They are exchange-traded funds (ETFs) that trade like stocks on exchanges and pool a collection of U.S. Treasurys. These funds offer regular monthly distributions but come with expense ratios paid to their asset managers. Treasury ETFs are highly liquid, and their prices fluctuate throughout the day. They are generally passively managed and have lower fees than mutual funds.

Individual bonds

Bonds are a promise made by a government or company to pay a guaranteed flow of interest in exchange for a loan. They are less volatile than equity and are popular because they have historically offered higher returns than cash, although not as strong as equities over the long term. Bonds are also used to diversify a portfolio away from equities. The bond markets are generally less transparent, liquid, and well-known to retail investors than the equity markets, so many prefer to get their bond exposure through funds, like ETFs.

For many investors, investing in the right bond funds can be a better option than holding a portfolio of individual bonds. Bond ETFs can provide better diversification, higher liquidity, and lower costs. They are also easier to implement and offer more flexibility in achieving targeted credit risk. However, there is a misconception that individual bonds should outperform bond ETFs, especially during periods of rising interest rates. This is because individual bonds can be held to maturity, avoiding potential losses. However, in reality, the investor is in the same position either way.

Bonds and interest rates have an inverse relationship. When interest rates change, bond prices adjust to keep the yield to maturity (YTM) of bonds with matching credit risk and maturity the same. So, if rates rise, older bonds with lower coupon rates drop in price to compete with similar newly issued bonds with higher coupon rates. Thus, both should offer the same expected return over the remaining period.

TreasuryDirect

To open an account on TreasuryDirect, individuals must have a valid Social Security Number or Taxpayer Identification Number (TIN), a US address and email address, and a checking or savings account. Once an account is opened, investors can choose the product type or term, source of funds, and the amount to purchase. Investors can also schedule the date of purchase, although dates are subject to availability.

If investors want to sell their Treasuries before the maturity date, they must transfer them to banks or brokerages. A Transfer Request Form must be completed to transfer Treasuries from a TreasuryDirect account.

ETFs, money market accounts, and the secondary market

Exchange-traded funds (ETFs) are bought and sold like stocks, and many qualify for commission-free trades. Investors can choose from government bond ETFs focused on short-term or long-term Treasuries, Treasury Inflation-Protected Securities (TIPS), and Floating Rate Notes (FRNs). Treasury ETFs can be held in IRAs and other tax-advantaged retirement accounts.

Treasury money market funds are a type of mutual fund that invests in short-term debt securities, typically those with maturities of less than 13 months. These funds aim to provide investors with a stable principal value, liquidity, and a competitive yield. Money market funds are considered low-risk investments and are often used by individuals looking for a safe place to park their cash while earning a modest return.

Money market ETFs are part of the money market fund (MMF) ecosystem. All MMFs, including Money Market ETFs, invest in ultra-short-term government debt and other fixed-income securities backed by excellent credit ratings. Money market ETFs prioritize the preservation of capital, liquidity, and returns that closely align with the overnight rate. The overnight rate is a rate of interest offered only to the largest and most secure financial institutions, such as banks, and it is usually calculated by the central bank that supervises the ETF's target market.

The primary market is where ETF shares are created and redeemed, while the secondary market is where they are traded among investors. Authorized participants (APs) are responsible for creating and redeeming ETF shares in the primary market by engaging directly with issuers. The creation-redemption mechanism ensures that an ETF's shares trade at a price close to its net asset value (NAV). The secondary market provides an extra layer of liquidity for ETFs by allowing market makers to match buyers and sellers throughout the trading day without impacting the primary market.

Interest rate changes

The inverse is also true; when interest rates fall, the price of bonds will rise. If an investor holds older bonds with higher interest rates than those currently on the market, they can sell them at a higher price.

Long-term bonds are more sensitive to interest rate changes than short-term bonds. This is because long-term bonds have a greater chance of being adversely affected by rising interest rates and inflation. Long-term bonds also offer higher interest rates to compensate for the greater volatility.

The impact of interest rate changes on bond prices can be measured by 'duration'. Duration tells you the approximate size of the capital gain or loss you can expect in response to a 1% change in interest rates. For example, a duration 2 ETF will drop about 2% in value if interest rates increase by 1%.

It's worth noting that interest rate changes don't just affect bond prices, but also stock prices. When interest rates rise, there is often downward pressure on stock prices. This is because investors may choose to invest in bonds that offer more attractive yields. Additionally, companies with debt may experience reduced profits due to higher borrowing costs, which can be reflected in lower stock prices.

However, the relationship between interest rates and stock prices is not always straightforward. For example, the Federal Reserve's interest rate cut in September 2024 was expected to bolster economic growth and prevent a rise in unemployment. This caused the stock market to go up, demonstrating the complex relationship between interest rates and equity valuations.

In summary, interest rate changes can significantly impact the value of bond ETFs and stock prices. Investors should carefully consider the potential effects of interest rate changes on their investment portfolios.

Tax efficiency

Treasury ETFs have some tax advantages over mutual funds because of their unique creation and redemption process, which can lower capital gains distributions. Income from Treasurys is generally exempt from state and local, but not federal, taxes.

ETFs are considered more tax-efficient than mutual funds because they typically have fewer "taxable events" in a conventional ETF structure than in a mutual fund. ETFs have a unique mechanism for buying and selling. They use “creation units” that allow for the purchase and sale of assets in the fund collectively. This means that ETFs usually don't generate the capital gains distributions that mutual funds do and, therefore, don't see the tax effects of those distributions.

The majority of ETFs are passively managed, which creates fewer transactions because the portfolio only changes when there are changes to the underlying index it replicates. Actively managed funds, in contrast, experience taxable events when selling the assets within them.

In general, holding an ETF in a taxable account will generate fewer tax liabilities than if you held a similarly structured mutual fund in the same account. However, investors who realise a capital gain after selling an ETF are subject to the capital gains tax. Currently, the tax rates on long-term capital gains are 0%, 15%, and 20%. These percentages are based on your taxable income and—depending on your modified adjusted gross income (AGI)—you might have to pay an additional 3.8%. The important point is that the investor incurs the tax after the ETF is sold.

ETF dividends are taxed according to how long the investor has owned the ETF fund. If the investor has held the fund for more than 60 days before the dividend was issued, the dividend is considered a “qualified dividend” and is taxed anywhere from 0% to 20% depending on the investor’s income tax rate. If the dividend was held for less than 60 days before being issued, then the dividend income is taxed at the investor’s ordinary income tax rate.

Certain international ETFs, particularly emerging market ETFs, have the potential to be less tax-efficient than domestic and developed market ETFs. Unlike most other ETFs, many emerging markets are restricted from performing in-kind deliveries of securities. Therefore, an emerging-market ETF might have to sell securities to raise cash for redemptions instead of delivering stock. This sale would cause a taxable event and subject investors to capital gains tax.

Leveraged/inverse ETFs have proven to be relatively tax-inefficient vehicles. Many of the funds have had significant capital gain distributions on both the long and the short funds. These funds generally use derivatives—such as swaps and futures—to gain exposure to the index. Derivatives cannot be delivered in kind: they must be bought or sold. Gains from these derivatives generally receive 60/40 treatment by the IRS, which means that 60% are considered long-term gains and 40% are considered short-term gains regardless of the contract's holding period.

Commodity ETPs have a similar tax treatment to leverage/inverse ETFs because of the use of derivatives and the 60/40 tax treatment. However, commodity ETPs do not have the daily index tracking requirement or use leverage/short strategies, and they have less volatile cash flows simply due to the nature of the funds.

The most tax-efficient ETF structure is exchange-traded notes (ETNs). ETNs are debt securities guaranteed by an issuing bank and linked to an index. Because ETNs do not hold any securities, there are no dividend or interest rate payments paid to investors while they own the ETN. ETN shares reflect the total return of the underlying index; the value of the dividends is incorporated into the index's return, but are not issued regularly to the investor. Thus, unlike with many mutual funds and ETFs that regularly distribute dividends, ETN investors are not subject to short-term capital gains taxes. But like conventional ETFs, when the investor sells the ETN, they are subject to a long-term capital gains tax.

Frequently asked questions