What it is:
Treasury notes, also known as T-notes, are intermediate-term bonds issued by the U.S. Treasury. They mature in two, three, five, or ten years
How it works (Example):
Treasury notes help fund shortfalls in the federal budget, regulate the nation's money supply, and execute U.S. monetary policy. Like any bond issuer, the U.S. Treasury considers the market's risk and return requirements in order to successfully and efficiently raise capital.
As with all Treasuries, T-notes are backed by the full faith and credit of the U.S. government. This means default is extremely unlikely and would really only occur if the U.S. government could not print additional money to pay off its debt. For this reason, the notes are generally considered risk-free investments and act as benchmarks against which other investments are compared. Their low risk and extremely high level of liquidity cause Treasury notes to usually have the lowest yields of any bonds on the market.
Birth of a Treasury Note: The Auction Process
First, the Treasury announces the sizes of any upcoming auctions and the bidding deadline. The Treasury then awards the securities to the highest institutional bidder first, then the second-highest, and so on. This way, the government takes in the most revenue. Individual investors can buy at the average price bid by the institutional dealers.
Ways to Purchase Treasuries
Institutional investors make up most of the market for Treasuries, but individual investors can easily purchase and trade the notes as well. Investors interested in purchasing Treasuries can do so directly from the Treasury Department's TreasuryDirect web site or through banks and brokers.
Many investors hold Treasuries through mutual funds. The fund-management fees do cut into returns, but the funds offer diversification among all the types and maturities of Treasuries, which is hard for the individual investor to achieve without significantly more cash than mutual funds require.
Why it Matters:
All investors, even those who don't own Treasury notes, should understand that Treasury rates affect the entire economy. This is partially because the government's sale or repurchase of Treasuries affects the money supply and influences interest rates. For example, when the Federal Reserve repurchases Treasuries, sellers deposit the proceeds at their local banks, which in turn lend to customers, who deposit their loan proceeds in their bank accounts, and so on. Thus, every dollar of Treasuries repurchased by the government increases the money supply by several dollars. This causes the supply of money for lending to increase, causing lending rates to fall.
T-notes are widely regarded as some of the safest investments around. They can be especially attractive for the most risk-averse investors and those primarily interested in preserving capital or maintaining a consistent stream of income. But there are several factors the investor should consider before investing -- interest rate risk, inflation risk, and taxes.