The Reality of U.S. Bond Investment: Understanding Interest Rate Fluctuations and Yields Properly

Many investors are seeking stable assets in an era of economic uncertainty. In particular, U.S. bonds are assets that serve as the benchmark for global financial markets, and Korean investors are increasingly paying attention to them. With low risk and high liquidity, U.S. bonds are attractive to investors who pursue both principal preservation and steady returns. In this article, we will explore the structure of U.S. bonds, investment methods, and the essential exchange rate risk management strategies that Korean investors must consider.

Basic Structure of Bonds and the Role of Government Bonds

Bonds are essentially certificates of debt, promising to repay borrowed money. The debtor repays the principal at maturity and, in return, pays periodic(interest—typically semiannually or once a year). When a government faces a shortage of funds for national operations, it issues bonds, known as ‘treasury bonds,’ to raise funds from citizens and institutional investors.

The most actively traded product in the U.S. bond market is the 10-year Treasury note. The 10-year note is mainly bought and sold for investment purposes rather than short-term holding, and it acts as the benchmark interest rate for the global financial market.

Three Types of U.S. Bonds and Their Characteristics

U.S. Treasury-issued bonds are classified based on maturity.

T-Bill(Treasury Short-term Securities) are ultra-short-term bonds with maturities under 1 year, offering almost no risk and excellent liquidity. T-Note(Treasury Medium-term Securities) have maturities of 1–10 years, suitable for medium-term investors, while T-Bond(Treasury Long-term Securities) have long maturities of 10–30 years. During uncertain economic times, these bonds become core defensive assets in investment portfolios.

Interest Rates and Yields: Understanding the Inverse Relationship

The most important concept in U.S. bond investing is the inverse relationship between interest rates and yields. Yield(refers to the expected return relative to the purchase price of the bond.

In the secondary market, bond prices fluctuate in real-time based on demand. When demand for safe assets increases, bond prices rise and yields fall. Conversely, when demand decreases, prices fall and yields rise. Ultimately, bond yields reflect market sentiment.

When interest rates rise, new bonds are issued at higher rates, causing the value of existing low-yield bonds to decline. If you need to sell before maturity, you may incur losses.

Four Strengths of Investing in U.S. Bonds

) 1. Unmatched Safety

U.S. bonds are among the highest credit-rated assets globally, backed by the U.S. government’s repayment guarantee. This is why investors flock to them during economic downturns. The risk of default is considered virtually nonexistent.

2. Stable Fixed Income

Interest rates are fixed at issuance, and interest is typically paid regularly—semiannually or annually. This provides a stable cash flow, making them ideal for retirees seeking reliable income.

3. Excellent Liquidity

U.S. bonds are actively traded 24/7 in the bond market. Investors can hold until maturity or liquidate immediately if needed, enhancing portfolio flexibility.

4. Tax Benefits

Interest income from U.S. bonds is subject to federal income tax but exempt from state and local taxes###. This can significantly boost after-tax returns.

Four Risks Investors Must Know

( 1. Interest Rate Risk

Rising interest rates cause the value of existing bonds to decline, especially for long-term bonds.

) 2. Inflation Risk

If fixed-rate bonds’ returns do not keep pace with inflation, real returns decrease. Inflation-linked bonds(TIPS) can help mitigate this risk.

3. Exchange Rate Risk

This is the most critical factor for Korean investors. When the dollar weakens, the converted KRW returns decrease.

4. Credit Risk

Theoretically, this refers to the possibility of U.S. government default, but given the high creditworthiness of the U.S., the actual risk is very low.

Three Ways to Purchase U.S. Bonds

( Method 1: Direct Purchase

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

Advantages: No commission fees, full receipt of interest and principal if held to maturity.

Disadvantages: Maximum limit of $10,000 per transaction, requires substantial funds and management for diversification, potential losses if sold early during rising interest rates.

Recommended for: Conservative investors aiming for long-term holding, retirees seeking regular income.

) Method 2: Bond Mutual Funds

Professionally managed funds that hold diversified bond portfolios.

Advantages: Diversification reduces risk of individual bonds, active management by professionals, accessible with small amounts.

Disadvantages: Management fees reduce returns, no control over individual bonds.

Recommended for: Investors seeking professional management, risk-averse investors pursuing stable long-term returns.

Method 3: Bond ETFs###Exchange-Traded Funds###

Funds that track specific bond indices and trade on stock exchanges.

Advantages: Lower fees than mutual funds, high liquidity and flexibility like stocks.

Disadvantages: Market volatility can impact prices, returns affected by trading costs and fees, lack of active management.

Recommended for: Investors seeking low-cost passive investment, believers in market efficiency.

Portfolio Strategies for Korean Investors

1. Importance of Currency Hedging

The biggest concern for Korean investors in U.S. bonds is exchange rate fluctuation. When the dollar weakens, the KRW value of holdings decreases.

Using derivatives like forward contracts for hedging can lock in exchange rates, reducing currency risk, but also diminishes potential returns.

A prudent approach is to hedge only part of the U.S. bond investment and keep some exposure. This way, investors can benefit from dollar strength while offsetting losses during dollar weakness.

2. Duration Management

Duration measures a bond’s sensitivity to interest rate changes. Investors should consider the duration of both Korean government bonds and U.S. bonds to align with their investment goals and risk appetite.

If preservation of principal is paramount, increasing the proportion of long-term U.S. bonds is an option. To reduce interest rate risk, a mix of bonds with shorter durations is advisable.

( 3. Tax Planning

Interest from U.S. bonds is subject to U.S. federal tax and also taxed in Korea. Due to the Korea-U.S. Double Taxation Agreement)DTA###, consulting a tax professional is essential to optimize tax treatment.

Portfolio Analysis: Combining Korean and U.S. Bonds

Suppose a balanced portfolio with 50% Korean government bonds and 50% U.S. bonds.

This diversification across regions and currencies reduces risks associated with specific economies. Holding assets in both KRW and USD can partially offset currency fluctuations.

For example, if 50% of U.S. bonds are hedged against currency risk, during dollar appreciation, the unhedged portion yields higher returns, while during dollar depreciation, the hedged portion protects against losses. This strategy leverages currency movements for efficient asset allocation.

Conclusion

U.S. bonds are a globally standard investment asset characterized by safety, stable returns, and high liquidity. However, investors must understand and manage risks such as interest rate fluctuations, inflation, and exchange rate movements.

For Korean investors, a balanced portfolio combining U.S. bonds and Korean government bonds is wise. Choosing among direct purchase, mutual funds, or ETFs should align with individual investment goals and risk tolerance. Considering currency hedging and tax optimization can further enhance the efficiency of U.S. bond investments.