The federal government raises money to fund its operations by issuing bonds in the capital markets. Investors can buy individual Treasury bonds or buy bonds through Treasury mutual funds. The federal government has essentially unlimited ability to pay its interest obligations, because it can tax the American people or print money to repay investors. Treasury bonds are considered risk-free investments, because Treasury bonds and the mutual funds they often trade in cannot go bankrupt.
Treasury Bond Mutual Funds
Mutual fund investment companies create Treasury bond mutual funds by pooling money from many investors and investing that money in different Treasury securities issued by the federal government. Investors receive a number of shares in the Treasury bond mutual fund proportional to the amounts they have invested in the fund. The securities in these funds are backed by the full faith and credit of the U.S. government, even though the fund itself is not backed by the government.
While the label "Treasury bond mutual fund" would suggest that the fund's holdings consist entirely of Treasury securities, this isn't always the case. Many Treasury bond mutual funds also hold other types of securities to boost the fund's returns. Some Treasury bond mutual funds may also hold U.S. agency bonds, corporate bonds, foreign bonds, zero-coupon bonds and derivatives. However, if a bond uses the word "Treasury" in its title, it must hold at least 65 percent of its investments in Treasury securities. This is a good reason to look closely at a fund's holdings before investing.
Interest Rate Risk
While Treasury bond mutual funds will never go bankrupt, there is always the risk of losing capital from having to sell shares at a lower price than you paid for them. Interest rates have a direct impact on the share price of Treasury bond mutual funds. Rising interest rates will cause the value of Treasury bond mutual funds to decline. But if interest rates begin to fall, share prices for Treasury bond mutual funds will increase.
Treasury bond mutual fund managers actively trade the holdings in the fund's portfolio to boost its returns. Therefore, the fund's shareholders have no control over the distributions of the capital gains in the fund. Treasury bond mutual funds that hold other types of bond securities are subject to some state and local taxes on the capital gains and interest they earn.
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