Core understanding of government bond investment: the path to safe returns

As the economy becomes more unstable, many investors turn their attention to safe assets. In particular, there has been a surge in individual investors seeking to learn how to buy government bonds. U.S. government-guaranteed U.S. Treasury bonds are perceived worldwide as the most trustworthy investment option. This guide will cover everything from the basic concepts of bonds to practical investment methods, as well as detailed strategies for Korean investors to manage exchange rate risk.

The Nature of Bonds and the Role of Treasury Bonds

Bonds are fundamentally financial certificates representing a credit relationship between the debtor and the creditor. They are contracts in which institutions or governments in need of funds borrow money from investors and agree to repay the principal at a set date.

Treasury bonds are bonds issued by the government to finance national operations. The issuing government pays interest biannually or annually and repays the full face value at maturity. Among the most actively traded products in modern financial markets is the 10-year U.S. Treasury note, which serves as a benchmark for assessing the long-term value of bonds and economic outlooks.

Classification and Yield Structure of U.S. Treasury Bonds

U.S. Treasury bonds are categorized into three types based on maturity periods:

Short-term securities(T-bill) have maturities of less than one year, carry minimal risk, and are quickly liquidated. They are preferred by investors seeking safety during economic downturns.

Medium-term securities(T-note) have maturities ranging from 1 to 10 years and offer moderate yields.

Long-term securities(T-bond) have maturities exceeding 10 years, provide fixed interest rates, but are more sensitive to interest rate fluctuations.

Understanding the concept of (yield) is crucial. Yield is the expected return at the time of bond purchase divided by the purchase price and fluctuates in real-time based on market supply and demand. If demand for Treasury bonds increases, bond prices rise and yields fall. Conversely, if demand decreases, prices fall and yields rise. This inverse relationship reflects investor sentiment and market conditions.

Four Major Benefits of Investing in U.S. Treasury Bonds

1. Top-tier reliability

The U.S. government’s repayment ability and commitment are unquestioned. During recessions, many investors shift assets into U.S. Treasury bonds, which carry virtually no default risk. This is the most conservative investment choice.

2. Stable cash flow

The fixed interest rate set at issuance remains unchanged until maturity. Regular interest payments, typically semiannually, make them ideal for retirees or investors seeking steady income.

3. Excellent market liquidity

U.S. Treasury bonds are among the most actively traded securities in the bond market. They can be easily sold when needed, with flexibility to hold until maturity or cash out mid-term. This liquidity greatly aids portfolio diversification.

4. Tax advantages

Interest income from Treasury bonds is subject to federal income tax but exempt from state and local taxes. This significantly enhances post-tax returns.

Four Risks Faced When Investing in U.S. Treasury Bonds

( 1. Interest rate risk

When interest rates rise, new bonds are issued at higher yields, causing existing bonds’ relative value to decline and potentially resulting in losses if sold before maturity. This risk becomes apparent when you need to liquidate early.

) 2. Inflation risk

Fixed interest income may not keep pace with inflation. If inflation exceeds bond yields, real returns can turn negative. Treasury Inflation-Protected Securities (TIPS) are designed to mitigate this, but regular bonds do not offer such protection.

( 3. Exchange rate risk

Particularly relevant for foreign investors. If the U.S. dollar weakens, the value of interest and principal in local currency decreases. Conversely, a strong dollar increases returns.

) 4. Credit risk of issuer

While the probability of default by the U.S. government is nearly zero, theoretically, political or economic crises could lead to default. However, due to the U.S.’s high credit rating, this risk is practically negligible.

How to Buy Treasury Bonds: Three Investment Routes

1. Direct Purchase

Buying directly from the government or through securities firms in the secondary market. Individual investors can use the U.S. Treasury’s TreasuryDirect website for direct transactions.

Advantages:

• No intermediary fees, leading to higher yields
• Full control over selecting and managing individual bonds
• Certainty of receiving regular interest and principal if held to maturity

Disadvantages:

• Purchase limit of up to $10,000 per transaction
• Managing multiple bonds for portfolio diversification can be burdensome
• Selling before maturity during rising interest rates may incur losses

Suitable for: Conservative investors planning to hold until maturity, retirees seeking regular income, investors who want to manage their portfolio directly

2. Bond Funds

Funds that pool investors’ money to create and manage diversified bond portfolios through professional fund managers.

Advantages:

• Diversification reduces risk associated with individual bonds
• Active management adapts to market conditions
• Access to broad bond markets with small investments

Disadvantages:

• Management fees reduce overall returns
• No direct control over individual bond selection

Suitable for: Investors seeking professional management, those wanting to avoid the hassle of managing individual bonds, risk-averse investors aiming for stable long-term returns

( 3. Index Tracking ETFs) (Exchange-Traded Funds)

Passive funds designed to track specific bond indices.

Advantages:

• Lower operating costs due to passive management
• High liquidity, tradable on stock exchanges like stocks
• Transparent index tracking with high predictability

Disadvantages:

• Market volatility affects returns regardless of underlying bond stability
• Slight differences from index returns due to management fees and trading costs
• No active adjustments to benefit from market shifts

Suitable for: Investors who want low-cost passive investment, those preferring direct market exposure, investors trusting market efficiency

Portfolio Strategies for Korean Investors

The Need for Integrated Investment

Investing simultaneously in Korean and U.S. Treasury bonds can diversify your portfolio. Since economic cycles differ between countries, downturns in one can be offset by booms in the other. Holding assets in both Korean won and U.S. dollars also spreads exchange rate risk.

Exchange Rate Risk Management Strategies

Exchange rate fluctuations directly impact returns for Korean investors. Hedging### strategies using derivatives like forward contracts can lock in exchange rates.

Full hedging eliminates currency risk but also forgoes potential gains from favorable exchange rate movements. Partial hedging is more practical. For example, hedging only 50% of U.S. Treasury investment exposes half to currency risk while allowing the other half to benefit from dollar appreciation, balancing risk and reward.

Duration Strategy

Duration measures a bond’s sensitivity to interest rate changes. For principal preservation, it’s advisable to hold long-term, stable U.S. Treasury bonds. If you want to minimize interest rate sensitivity, mixing in shorter-term medium bonds is effective.

Tax Optimization

Interest income from U.S. Treasury bonds is taxed by the U.S. federal government and may also be taxed in Korea. Although a double taxation treaty(DTA) exists, investors should consult tax professionals to determine precise tax treatment.

Real Portfolio Example

Consider a balanced portfolio with 50% Korean bonds and 50% U.S. Treasury bonds. This setup aims for principal preservation and regular income.

Limiting exposure to economic risks of a single country reduces overall portfolio risk. Hedging 50% of U.S. Treasury holdings against exchange rate fluctuations can protect half of the dollar-denominated assets.

During periods of dollar strength, unhedged portions increase in local currency returns. Conversely, during dollar weakness, hedged portions offset currency losses. This balanced approach seeks stable returns across various market conditions.

Conclusion

Understanding U.S. Treasury bonds and how to buy bonds is fundamental to building a stable investment portfolio. Recognizing and managing risks such as interest rate, inflation, and exchange rate fluctuations is crucial.

For Korean investors, combining domestic bonds with U.S. Treasury bonds can further strengthen portfolio resilience. Choosing among direct purchases, funds, or ETFs based on your investment style and goals can lead to long-term asset growth and stability.