Understanding the Yield Mechanism Before Investing in U.S. Treasury Bonds

There is a growing number of Korean investors seeking the most stable investment options in the global financial markets. Especially as economic uncertainty increases, U.S. Treasury bonds are gaining attention as a representative safe asset worldwide. Despite seemingly low surface interest rates, their advantages include high liquidity for immediate cashing and the U.S. government’s repayment guarantee. In this article, we will explore the core mechanisms of U.S. Treasury bond investments and practical strategies that Korean investors can implement step by step.

Basics of the Bond Market: The Relationship Between Interest Rates and Yields

Many investors use the terms ‘interest rate’ and ‘yield’ interchangeably when referring to bonds, but strictly speaking, they are different.

A bond is essentially a debt certificate. The government or corporation borrows funds from investors, repays the principal at a fixed maturity date, and in the process, pays periodic (interest), usually semiannually or once a year (. The U.S. government also issues ‘Treasury bonds’ to cover budget shortfalls needed for national operations. Among these, the 10-year U.S. Treasury note is the most actively traded instrument in the secondary market and serves as a key indicator reflecting market sentiment.

U.S. Treasury bond yield is expressed as the ‘yield)’, which is the expected return divided by the purchase price. Unlike the fixed interest rate at issuance, it fluctuates in real-time in the secondary market.

As demand for bonds changes, their prices move, and so do their yields. When safe asset demand increases, bond prices rise and yields fall. Conversely, when demand decreases, prices fall and yields rise. Therefore, U.S. Treasury bond yields and prices move inversely, accurately reflecting market sentiment.

Classification and Characteristics of U.S. Treasury Bonds

The U.S. government issues three types of bonds based on maturity:

T-bill(: Short-term Treasury bills): Maturities under 1 year, with minimal risk and high liquidity. Suitable for short-term cash management.

T-note(: Treasury notes): Maturities between 1 and 10 years, ideal for investors with medium-term investment goals.

T-Bond(: Treasury bonds): Maturities from 10 to 30 years, offering fixed interest rates. Mainly purchased by retirees or institutional investors seeking long-term income.

During economic downturns, these bonds become core assets for portfolio diversification. Additionally, U.S. Treasury yields serve as benchmarks for risk-free returns in global financial markets, with the 10-year yield being a key indicator of the overall health of the economy.

Generally, longer maturities should command higher yields, but as a recession approaches, demand for long-term bonds surges, leading to an inverted yield curve where long-term yields fall below short-term yields. This is interpreted as a recession signal.

Four Practical Advantages of Investing in U.S. Treasury Bonds

1. Top-tier Safety

The risk of U.S. government default is extremely low in reality. Even during economic crises, investors flock to U.S. Treasuries, indicating that the risk of default is virtually negligible.

2. Fixed Return Structure

The fixed interest rate is set at issuance, with interest paid periodically (, usually semiannually). This makes it an excellent choice for retirees or conservative investors needing regular cash flow.

3. Excellent Liquidity

The U.S. Treasury market is the largest bond market in the world, with daily trading volume in the trillions of dollars. Bonds can be sold easily whether holding to maturity or needing quick cash. This high liquidity greatly aids portfolio diversification.

4. Tax Benefits

Interest income from Treasuries is subject to federal tax but exempt from state and local taxes. Korean investors can also benefit from this, increasing after-tax returns.

Four Risks Often Overlooked

1. Interest Rate Risk

When market interest rates rise after purchase, newly issued bonds offer higher yields. Existing bonds with lower yields become less attractive, causing their prices to fall. Selling before maturity during rising rate periods can result in losses.

2. Inflation Risk

Fixed-rate bonds may not keep pace with rising prices. If inflation exceeds the U.S. Treasury bond yield, real returns can turn negative. TIPS (Treasury Inflation-Protected Securities) are designed to hedge against this, but regular bonds are not.

3. Currency Risk(: Especially relevant for Korean investors)

When investing in U.S. Treasuries, the primary concern is exchange rate fluctuations. If the dollar weakens against the Korean won, both the interest income and principal converted into won decrease in value, reducing overall returns.

4. Credit Risk

Theoretically, there is a possibility that the U.S. government might default. However, considering its historical creditworthiness and current economic standing, this risk is extremely low.

Three Ways to Purchase U.S. Treasury Bonds

The optimal method varies depending on the investor’s capital size, risk appetite, and time commitment.

( Method 1: Direct Purchase

Buy directly from the U.S. Treasury via the TreasuryDirect website or through securities firms in the secondary market.

Advantages: Full control over buying and selling decisions, no management fees. Holding to maturity yields regular interest and principal payments.

Disadvantages: Individual investors are limited to $10,000 per transaction on TreasuryDirect. Diversification requires managing substantial capital. Selling before maturity during rising rate periods may incur losses.

Suitable for: Long-term investors planning to hold until maturity, retirees needing steady income, investors who prefer managing their portfolio directly.

) Method 2: Mutual Funds(Bond Funds)

Pooling funds from multiple investors to create diversified bond portfolios managed by professional fund managers.

Advantages: Exposure to various bonds reduces risk associated with individual bonds. Active management adjusts portfolios according to market conditions. Allows small investments across many bonds.

Disadvantages: Management fees reduce net returns. No direct control over individual bonds.

Suitable for: Investors with limited time or those preferring professional management, risk-averse investors seeking stable long-term returns through diversification.

( Method 3: Exchange-Traded Funds (ETFs))

Passive funds tracking U.S. Treasury bond indices, traded on stock exchanges like stocks.

Advantages: Lower management fees compared to active funds. High liquidity and flexibility due to stock exchange trading.

Disadvantages: Subject to stock market volatility. Tracking errors may occur. Limited potential for outperforming the index through active management.

Suitable for: Investors seeking low-cost exposure to Treasuries, passive investors trusting market efficiency, those wanting direct control over their investments.

Strategic Approaches for Korean Investors

Currency Risk Management

The most significant concern for Korean investors in U.S. Treasuries is exchange rate fluctuation. Currency risk involves the uncertainty of the won value changing as the dollar moves.

Hedging involves using derivatives like forward contracts to lock in exchange rates in advance. While this reduces currency risk, it also sacrifices potential gains from favorable currency movements.

An effective strategy is to hedge only part of the investment amount, leaving the rest exposed. For example, if investing $10,000, hedging only $5,000 limits losses from dollar depreciation to 50% while allowing full benefit from dollar appreciation.

Duration Adjustment

Duration measures a bond’s sensitivity to interest rate changes. Longer maturities generally have higher durations.

By harmonizing the durations of Korean and U.S. bonds, investors can control overall interest rate risk. For principal preservation, include longer-duration bonds; for short-term income, opt for bonds with shorter durations.

( Tax Optimization

Interest from U.S. Treasuries is taxed by the U.S. federal government and may be subject to Korean taxation. Fortunately, the Double Taxation Agreement (DTA) between Korea and the U.S. prevents double taxation on the same income. Consulting tax professionals to maximize applicable benefits is essential.

Example Portfolio Composition

Suppose a balanced portfolio with 50% Korean bonds and 50% U.S. Treasuries. This setup aims to achieve both principal preservation and income generation.

Advantages: Reduces dependence on a single economy’s performance, mitigating structural risks. Holding assets in both won and dollar terms naturally hedges against currency fluctuations.

Currency Management Example: Hedging only 50% of the U.S. Treasury portion ($5,000). During dollar strength, unhedged parts increase in won value; during dollar weakness, hedged parts offset losses.

Conclusion

Investing in U.S. Treasuries is a global standard choice for investors seeking safety and predictable returns. However, understanding and strategically managing U.S. Treasury yield fluctuations, inflation, and currency risks are crucial.

For Korean investors, diversification beyond domestic bonds through U.S. Treasuries, combined with currency hedging and duration management, can optimize portfolios. Choosing among direct purchase, funds, or ETFs according to capital and investment style is the first step toward successful Treasury bond investment.