Can You Lose Money on Treasury Bonds?

Treasury bonds, notes, and bills are debt securities issued by the U.S. Department of the Treasury, representing loans made by investors to the federal government. These instruments are backed by the “full faith and credit” of the U.S. government, making them among the safest investments available due to an extremely low default risk. Investors lend money to the government, receiving regular interest payments and their original investment back at maturity. Despite their safety reputation, investors can experience a “loss” on Treasury securities under specific market conditions. This article explores when such losses can occur.

Understanding Interest Rate Risk

Changes in prevailing interest rates present a significant risk to the market value of existing Treasury bonds, known as interest rate risk. This risk arises from the inverse relationship between bond prices and interest rates: as market interest rates rise, the market value of bonds previously issued with lower rates tends to fall. New bonds offer more attractive, higher yields, making older bonds with fixed, lower coupon payments less appealing to buyers.

If an investor holds a Treasury bond until maturity, they receive the full principal and all scheduled interest payments. In this scenario, rising interest rates result in a “paper loss” or unrealized loss, meaning the portfolio shows a lower value but no actual cash loss. A monetary loss occurs if the bond is sold before maturity when interest rates have risen since purchase. For example, if a 10-year Treasury bond yielding 3% was bought and market rates climbed to 4%, its market price would drop to become competitive, leading to a capital loss upon sale.

A bond’s price fluctuation in response to interest rate changes depends on its coupon rate and time to maturity. Longer maturities are more sensitive to interest rate fluctuations than shorter ones, meaning their prices change more significantly for a given interest rate shift. For instance, a 30-year Treasury bond experiences greater price volatility than a 2-year Treasury note if interest rates shift. Bonds with lower coupon rates also exhibit higher interest rate sensitivity, as more of their total return comes from the principal return at maturity.

Understanding Inflation Risk

While interest rate fluctuations can lead to capital losses if bonds are sold prematurely, inflation presents a different risk: eroding the purchasing power of returns from traditional fixed-rate Treasury bonds. This involves distinguishing between “nominal return” and “real return.” Nominal return is the stated interest rate received. Real return accounts for inflation, representing the actual increase in purchasing power after adjusting for rising prices.

For investors in fixed-income securities like Treasury bonds, inflation risk means that even if full principal and interest payments are received, those dollars may buy less than when the bond was purchased. For example, if a bond pays a 3% nominal return but inflation is also 3%, the real return is effectively zero. The money received has the same purchasing power as the initial investment, as fixed interest payments become less valuable over time in an inflationary environment.

The “loss” due to inflation is not a loss of the dollar amount, but a reduction in the economic value of those dollars. This differs from capital loss due to rising interest rates, which directly impacts the bond’s market price. Inflation risk concerns investors holding bonds for income, as the fixed income stream may not keep pace with the rising cost of living. Longer-term bonds face greater inflation risk because inflation’s impact compounds over extended periods, diminishing the real value of future payments.

Treasury Inflation-Protected Securities (TIPS)

Treasury Inflation-Protected Securities (TIPS) are a type of Treasury bond designed to shield investors from inflation. Unlike traditional fixed-rate bonds, the principal value of TIPS adjusts periodically based on changes in the Consumer Price Index (CPI). When inflation rises, the principal value of a TIPS increases; it decreases during deflation.

Interest payments on TIPS are semi-annual, calculated as a fixed coupon rate applied to the inflation-adjusted principal. As the principal value rises with inflation, the dollar amount of interest payments also increases, providing an income stream that keeps pace with rising prices. This helps preserve the purchasing power of an investor’s capital and income over the bond’s life.

While TIPS offer inflation protection, they are not entirely risk-free and can experience market price fluctuations if sold before maturity. Their market value can be affected by changes in real interest rates, even if nominal interest rates remain stable. For instance, if real interest rates increase, the price of existing TIPS may decline.

A unique aspect of TIPS taxation is that inflation adjustments to the principal are generally considered taxable income in the year they occur, even though the investor does not receive this cash until the bond matures or is sold. This “phantom income” requires investors to plan for tax liabilities on income not yet received. In periods of deflation, the principal value of TIPS can decrease, but at maturity, investors are guaranteed to receive no less than their original principal amount.