What is a Treasury Bill?
A Treasury Bill also referred to as a T-bill, is a U.S. government short-term debt obligation backed by the Treasury Department, thus the term Treasury Bill. T-bills tend to be short in maturity usually a year or even less. It is important to note here that the longer the maturity date the higher the interest rate that the T-bill will pay to the investor is. Many investors already know that securities like these have inherently low-risk and are more secure than other securities. However, due to the low risk, the return is also low.
How does a Treasury Bill work?
The Treasury Department sells T-bills in auctions using a competitive and a non-competitive bidding process. Non-competitive bids are also known as non-competitive tenders, are priced on the average of all competitive bids received. What attracts investors to T-bills is the high tangible net worth, meaning that it can easily be converted into cash.
T-bills are most of the time sold in denominations of $1,000 while some can reach a maximum price of up to $5 million!!
Bidders can be hedge funds, banks, primary deals or individual investors. A competitive bid sets the price at a discount from the T-bill’s par value and the investor can specify the yield. These bids are made through a local bank or a licensed broker. Noncompetitive bids allow investors to submit their own offers via the TreasuryDirect website. Once completed the government states that it owns the investor the money invested.
Why does the U.S. government issue T-bills?
The U.S. government issues T-bills to fund various projects in the country. For example, this can be construction works for new schools, new highways, etc. When one T-bill is sold to an investor, he/she receives an IOU that is written by the government.
What is an IOU?
An IOU is an acronym for “I owe you” and is a document that states the existence of a debt. It is an informal written agreement compared to a formal legally binding agreement.
Investors might choose to cash out the T-bills before the maturity date and realize the short-term interest gains by reselling them to them in the secondary market.
What is the secondary market?
Many investors do not realize that the secondary market is the stock market. The New York Stock Exchange and the Nasdaq are both secondary markets. This is because many stocks are being sold on the primary market when they are first issued.
T-bills most common maturities are 4,8,13,26 and 52 weeks. The longer the maturity date, the higher the interest rate that the T-Bill will pay to the investor.
Pros and Cons of Investing in T-bills
- Zero default risk since T-bills have a U.S. government guarantee.
- T-bills offer a low minimum investment requirement of $100.
- Easy to buy and sell T-bills I n the secondary market.
- Interest return is not taxed by local authorities or state authorities but are subject to federal income taxes.
- T-bills have interest rate risk, so, their rate could become less attractive in a rising-rate environment.
- Offer low returns compared to other debt instruments
- The T-Bill pays no coupon—interest payments—leading up to its maturity.
What affects the T-bills prices?
Just like any other debt security T-bills are fluctuating in the same manner. Main reason for fluctuation can be macroeconomic conditions, monetary policy, and the overall supply and demand for Treasuries.
The monetary policy set by the Federal Reserve has a strong impact on the T-bill prices. The federal reserve is responsible for the interest rates that banks charge other banks for lending them money from their reserve balances on an overnight basis. The Fed will usually implement a change in the interest rates in order to expand the monetary policy whether this means to increase or decrease the fed funds of money in the economy.
Therefore, the Federal reserve’s decision has a direct impact on the T-bills and short-term interest rates. As a result, the federal funds rate tends to be the reason that investors will put their money elsewhere into a higher-yield investment. Since T-bills have fixed interest rates investors will sell their T-bills when interest rates go higher than normal because the T-bill rates are less attractive. Conversely, if the Fed is cutting interest rates, money flows into existing T-bills driving up prices as investors buy up the higher-yielding T-bills.
One of the largest purchasers of government debt securities is Federal Reserve. When the Federal Reserve purchases U.S. government bonds, bond prices rise while the money supply increases throughout the economy as sellers receive funds to spend or invest. Funds deposited into banks are used by financial institutions to lend to companies and individuals, boosting economic activity.
T-bill prices fall when the Fed sells its debt securities and vice versa.
Example of T-bills
Let’s assume that an individual investor purchases a T-bill with a competitive bid of $950 and the par value of the T-bill is $1,000. When the T-bill matures the investor will then get paid $1,000 and thereby earn $50 on its T-bill. T-bills are zero-coupon bonds meaning that the accrued interest for investors is usually the difference between the discounted purchased price and the par value.