How is the interest rate on a treasury bond determined?

The yield of U.S. Treasury securities, including Treasury bonds (T-bonds), depends on three factors: the face value of the security, how much the security was purchased for and how long it is until the maturity of the security. Many external factors influence Treasury prices and yields, such as the monetary policy of the Federal Reserve and the perceived health of the economy.

T-bonds don't carry a interest rate as certificates of deposits (CDs) might. Instead, a set percent of the face value of the bond is paid out at periodic intervals. This is known as the coupon rate. For example, a $10,000 T-bond with a 5% coupon will pay out $500 annually, regardless of what price the bond is trading for in the market.

This is where current yields become important. Debt instruments don't always trade at face value. If an investor purchases that same $10,000 bond for $9,500, then the rate of investment return isn't 5% – it's actually 5.26%. This is calculated by the annual coupon payments ($500) divided by the purchase price ($9,500).

As the previous example demonstrates, the yield on a bond rises when the purchase price of the bond drops. T-bond purchase prices are determined by the supply and demand for Treasury debt; prices are bid up when there are more buyers in the market.

Treasury debt is considered extremely safe by the investing community. Since the government has its own printing press in the Federal Reserve, there is virtually no chance of the Treasury department defaulting on its bond obligations. This means that Treasury rates are very important.

When times are uncertain, investors tend to take money out of riskier assets, such as junk bonds or equities, and put them into relatively safe assets. This extra demand bids up T-bond prices and, by extension, pushes down T-bond yields.