The U.S. government issues several types of bonds, and interest is paid differently for several of the types. For investors, the ability to compound interest is positive for the growth of a portfolio. Compounding is earning interest on interest as the value of a bond or account grows. Choosing a government bond for investment depends on the investor's goal, current income or compounding growth.
U.S. Savings Bonds
Series EE and I savings bonds earn interest which compounds to the value of the bonds. Savings bonds are savings certificates sold through banks or the Treasury Direct (treasurydirect.gov) website. A series EE bond earns a fixed rate of interest for the life of the bond and a series I bond earns interest which is adjusted for inflation twice a year. Bond types of savings bonds accrue interest monthly and compound the interest semi-annually. Every six months, the monthly interest calculation is adjusted to include the accrued interest from the previous six months.
Treasury Notes and Bonds
Treasury notes and bonds are marketable securities sold by the Treasury Department through an auction process. Notes and bonds are issued to pay a fixed rate of interest called the coupon rate. A $10,000 treasury note with a seven percent coupon rate pays an investor $700 per year interest in two semi-annual payments of $350 each. The interest from notes and bonds paid out to investors is simple and does not compound. Notes and bonds can sell at a premium or discount to the face amount, resulting in an investment yield different than the coupon yield. The investment yield, called the yield to maturity, includes the effect of the price premium or discount in the return to an investor.
Treasury bills are a third type of government bond with a different method of paying interest. Treasury bills are issued with maturities of three to 52 weeks and sold at a discount to the final value. For example, a one-year treasury bill with a face value of $100,000 could sell for $97,000. The $3,000 difference is the interest to be earned on the bill. This bill has a discount rate of three percent, but the yield to the investor will be higher because the $3,000 is earned on an investment of $97,000. The actual yield on a treasury bill is called the bond equivalent yield and is simple interest. For the example treasury bill, the bond equivalent yield would be 3.093 percent.
Compounding Government Bond Simple Interest
Savings bonds are the only government bond type with compounding interest, and savings bonds can only be purchased in limited amounts. To compound the earnings of marketable treasury bills, notes and/or bonds, one solution is to invest in treasury securities through a treasury bond mutual fund. Bond investing through mutual funds allows interest earned and paid as dividends to be automatically reinvested into more fund shares. The result will be a compounding of the government bond interest as the number of shares in the investor's account grows.