How Does a Treasury Note (T-Note) Work?

A Treasury Note, often referred to as a T-Note, is a debt security issued by the U.S. Department of the Treasury. This financial instrument allows the government to borrow money from the public to fund its operations and expenses. These securities are recognized for their high degree of safety within the investment landscape. They are backed by the full faith and credit of the U.S. government, making them a secure choice for investors seeking to protect their principal.

Key Characteristics of Treasury Notes

Their maturity periods typically range from two to ten years, specifically issued in terms of 2, 3, 5, 7, and 10 years. This intermediate maturity distinguishes them from shorter-term and longer-term government securities.

A fixed interest rate, known as the coupon rate, is a hallmark of T-Notes. This rate is determined at auction and remains constant throughout the life of the note. Interest payments are made to the note holder every six months until the maturity date.

Treasury Notes are commonly issued in denominations of $100. At the end of the specified maturity period, the note holder receives the full face value of the security. The safety of T-Notes is attributed to the backing of the U.S. government, which ensures timely interest and principal payments. Their highly liquid nature means they can be easily bought and sold in the financial markets, offering flexibility to investors.

How Treasury Notes are Acquired and Traded

New Treasury Notes are introduced to the market through a public auction process conducted by the U.S. Department of the Treasury. These auctions are regularly scheduled events where both individual and institutional investors can participate. The interest rate for newly issued T-Notes is established during these auctions.

Individual investors can participate directly in these primary market auctions through TreasuryDirect, the official government website. When using TreasuryDirect, investors typically submit non-competitive bids, meaning they agree to accept the interest rate determined by the auction’s competitive bidding process. This method guarantees that the investor will receive the security in the desired amount, though the specific yield is not known until the auction concludes.

Alternatively, investors can acquire Treasury Notes through banks, brokers, or dealers. These intermediaries allow for both non-competitive and competitive bids. Competitive bids enable investors to specify the yield they are willing to accept, though there is a risk that their bid may not be accepted if it falls outside the market-clearing rates.

While direct purchases through TreasuryDirect typically incur no fees, transactions through brokers or dealers may involve commissions or other charges. Once issued, Treasury Notes can be bought and sold on the secondary market before their maturity date. This market operates through a network of brokers and dealers, providing investors with the flexibility to sell their notes if they need access to their funds sooner. The price of a T-Note in the secondary market can fluctuate based on prevailing interest rates and market demand. If interest rates rise after a note is issued, its secondary market price may fall, and conversely, if rates decline, its price may increase.

Taxation of Treasury Notes

Interest earned on T-Notes is subject to federal income tax. This interest income must be reported on the investor’s federal income tax return and is taxed at the investor’s ordinary income tax rate.

The interest income they provide is exempt from state and local income taxes. This exemption can offer significant tax savings, particularly for individuals residing in areas with high state or local income tax rates.

Should a Treasury Note be sold on the secondary market before its maturity date, any capital gain or loss realized from the sale is subject to federal capital gains tax rules. A capital gain occurs if the selling price exceeds the purchase price, while a capital loss occurs if it is sold for less. Long-term capital gains, from notes held for over one year, generally receive a more favorable tax treatment than short-term gains, which are taxed as ordinary income.

In cases where a Treasury Note is acquired at a discount directly from the Treasury and held until maturity, the difference between the discounted purchase price and the face value at maturity is considered Original Issue Discount (OID). This OID is generally treated as interest income for tax purposes and is subject to federal income tax over the life of the note, even if the cash is not received until maturity.

Comparing Treasury Notes to Other Securities

Treasury Bills, or T-Bills, are short-term debt instruments with maturities typically ranging from four weeks up to one year. Unlike T-Notes, T-Bills do not pay semi-annual interest; instead, they are sold at a discount to their face value, and the investor receives the full face value at maturity, with the difference representing the return.

Treasury Bonds, or T-Bonds, represent the longest-term U.S. government debt, with maturities of 20 or 30 years. Similar to T-Notes, T-Bonds pay fixed interest every six months. The primary distinction between T-Notes and T-Bonds is their maturity length.

Another type of Treasury security is Treasury Inflation-Protected Securities, or TIPS. These securities are unique because their principal value adjusts with changes in the Consumer Price Index, offering protection against inflation. While T-Notes provide a fixed interest rate, TIPS adjust their principal and interest payments for inflation.