T-Bills 101

In this episode we explain the basics of the US treasury market, what it is, why it exists and how to invest in government-issued debt. The hosts address the meaning of the yield curve, what it’s telling us and why the yield curve today has an inverted look about it.

Related Links:

 TreasuryDirect: https://treasurydirect.gov/ 

Bloomberg Chart: https://www.bloomberg.com/news/articles/2022-10-15/bruised-bond-bulls-see-rate-hike-pain-sowing-seeds-of-2023-rally#xj4y7vzkg

Summary – Cents of Security Ep. 18

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Mary MacNamara

Welcome everybody. Here we are at Cents of Security and today’s topic is the US Treasury market. I’m here with Andrew Wilkinson and I’m Mary MacNamara . So, let’s start. Andrew, what are T-bills and why are we hearing about them in the news so often?

Andrew Wilkinson

Treasury bills, and the treasury market in general, is how the US Government manages its debt. It raises money by issuing bonds and depending on the maturity of those bonds, they’re known as bills, notes or bonds. So, a Treasury bill has a maturity date of less than two years out. So, it’s a short-term cash management tool of the US government and managed by the Federal Reserve. So, in the past couple of years, what has happened is the Federal Reserve in charge of monetary policy has been increasing interest rates, tightening monetary policy, and so the yield spectrum: We’ll talk a bit more about the maturity curve later on. Yields have been rising, particularly for shorter dated maturities, which is exactly what treasury bills are, and this is one reason that they are so popular is because of their short-term duration and nature, they make good investments for people who want to tie up money in a very short period of time. And I think as of the time of recording, (we’re towards the end of September), the one-year treasury rate was at about 5.47%. That compares to a yield last year at about 4.15%. So, short term interest rates, driven by the Federal Reserve, have been lifted to about 5.25% to 5.50%. So, the commensurate treasury yield is going to be around there. And, what we’re going to show in the show notes, Mary, is a great chart going back to about 1960-1950 which shows the path of treasury yields over that 50/60/70 year-period and we haven’t actually put the average on there, but the average if you would have put an average horizontal line through it would be about 2.91%. And so, 5.47% current yield is very, very high and potentially very appealing to those who have money to invest or deposit. So, some of the facts to consider are:

Treasury bills are considered low risk and secure investments because they’re backed by the full faith and credit of the US government and they tend to be sold in denominations of $1000 units, although some denominations can reach as high as $5,000,000.

Treasury bills are issued at a discount from their face value, and they don’t pay regular interest payments like regular bonds that carry a so-called coupon and instead that interest amount is reflected in the amount that the treasury bill pays when it matures. Let me give you a quick example here. So, if we’re talking about a $1000 face value treasury bill that matures in exactly 1-year’s time. OK, what does that mean? That means that at maturity, the investor will get back the $1000. So, when they purchase the bond at the outset today, the amount of interest is calculated over the duration of the bond, the maturity of the bond. And let’s say it’s $40.00 of interest. What do we do? We subtract from $1000 the $40 interest payment, which gives $960. That is the investment amount that will return at maturity in a year’s time, $1000 face value.

Mary MacNamara

If I write a check for $960.00 for this T-bill that matures in one year, what happens if the rate changes during that year? So, let’s say at the end of the year the rate is less, like 3%. Would I only get $30 in interest?

Andrew Wilkinson

No, you’ve locked into the price of the bond. It doesn’t matter what happens to interest rates for the duration, you’re going to get back your $1000 at that time. So, in this case, the government, through the Department of Treasury, promises to pay the investor the full par value of $1000 for that T-bill in a year’s time.

Now T- bills come with a range of different maturities. The most common ones, though, are for four or eight weeks, one or two-month treasury bills. They can also have maturities of 13 weeks, 17 weeks, 26 weeks, which is half a year, a six-month bill or 52-weeks. And of course, they can expand to as far as two -years to keep them classified as treasury bills. An important fact is the interest earned on treasury bills is exempt from state and local taxes, but it’s fully taxable at the federal level. So, watch out for that.

Mary MacNamara

So how do you purchase Treasury bills?

Andrew Wilkinson

The Treasury Department sells treasury bills through weekly auctions. In fact, they can pretty much auction at any time. And there are two different bidding processes. There’s a competitive bidding process and a non-competitive bidding process. Let’s go through both of those. For the non-competitive bid, the investor agrees to accept the discount rate determined at the auction. The yield that an investor receives is equal to the average auction price for treasury bills sold at the auction. Individual investors prefer this method since they’re guaranteed to receive the full amount of the bill at the expiration of the maturity period, and payment may be made through Treasury direct. We’ll put that link in the show note later, or through the investors’ bank or broker. Now, there’s also a competitive bidding auction. In a competitive bidding auction, investors buy treasury bills at a specific discount rate that they are willing to accept. So, it’s like putting a limit price on something. Every submitted bid states the lowest rate or discount margin that the bidder or the investor is willing to accept. Bids accepting the lowest discount rate are accepted first. So, if there are not enough bids at that level to make the issue fully subscribed I.e. for the Treasury to sell all the bills it wants to, then bids at the next lowest rate are accepted and the process continues until the entire issue or tranche has been sold and purchase payments must be made either through a bank or a broker. So, that’s what you’d call the primary market for treasury bills. But there’s also a secondary market, so investors can buy or sell treasury bills in the secondary market from market makers such as brokers and both retail and investment banks. And those institutions will often charge a bid, offer margin, a spread, in order to make the trade profitable for them. Other big investors in Treasury bills include mutual funds and exchange traded funds. Other investors in this field investing in short-term government debt would include mutual funds, called money market funds, and exchange traded funds, or ETF’s. They both actively invest in treasury bills as well as investors who are looking for another place to park their cash.

Mary MacNamara

What affects the price of T-bills or treasuries?

Andrew Wilkinson

That’s a good question, Mary. Prices are on the move all the time and fairly much influenced by two things: Both economic activity but also the expected path of monetary policy. We mentioned the Federal Reserve earlier. So, those are the two big driving factors. What usually happens is that interest rates are driven higher when the economy heats up and expands and is running at full capacity. The Federal Reserve might want to slow down economic activity and to do that, it can tighten monetary policy and that has an impact on T-bills. And you’ll also see there’s a similar effect on yields and prices of bonds in response to economic data. So, the price of T-bills can fluctuate based on factors such as macroeconomic conditions, monetary policy, and the supply and demand for treasuries. That’s really important. The US government issues debt when it needs to plug a hole in its borrowing requirement. So, the more it borrows, the more it has to issue, and the more it comes to the market. There have been occasions when either the US Treasury or other governments around the world have not had such a large borrowing requirement and that means that treasuries or the equivalent local government bond markets have died down because of a lack of supply. Like in this country in the United States, there tends to be a lot of demand for ultra safe securities or treasuries, treasury bills, treasury notes, and so on. The Federal Reserve’s monetary policy is likely to affect the Treasury bill price. Treasury bill interest rates tend to move closer to the interest rate set by the Fed, known as the federal funds target rate or the fed funds rate. But a rise in the fed funds rate means that existing Treasury bill prices fall in order to make those securities attractive to investors. When I say fall, I’m talking about the price. When prices fall, yields tend to rise and then new investors can buy higher yielding treasury bills at lower prices to reflect that higher yield. The maturity period of a Treasury bill also affects its price. For example, a 1-Year treasury bill typically comes with a higher rate of return than does a three-month treasury bill and the explanation for this is wrapped up in what’s called the time value of money, and that means that longer maturities carry additional risk for investors in a normal interest rate environment. So, a $1000 face value treasury bill might be sold for $970 for a three-month duration, but a six-month duration might cost $950 and a 12-month treasury bill might cost $900.00. So, the smaller initial investment is associated with a larger, at maturity, interest payment and investors typically demand a higher rate of return to compensate them for tying up their money for a longer period of time. And investors’ risk tolerance level also affects the price of a treasury bill when the US economy is going through an expansion and other debt securities are offering higher returns, treasury bills are less attractive and will, therefore, be priced lower. However, when the markets and the economy are volatile and other debt securities are considered riskier, treasury bills command a higher price for their so-called safe haven quality. And the price of treasury bills can also be affected by the prevailing rate of inflation since inflation, typically eats away at the real purchasing power of the Treasury bill, as it’s priced in dollars. So, if the inflation rate stands at 8% and the Treasury bill discount rate is 5%, it becomes uneconomical to invest in Treasury bills since the real rate of return will be at a loss. And the effect of this is that there is less demand for treasury bills and then their price will drop.

Mary MacNamara

So, here’s a little fact for you, Andrew. Did you know that the T-bills have other Treasury friends known as treasury notes and T-bonds. They are also known as the treasuries.

Andrew Wilkinson

Yeah, indeed, Mary, that’s one of my bugbears, is that people refer to what are actually notes as bonds and bonds as notes and it needs a bit of explanation here. The Treasury Department spreads out their borrowing over various maturities to ensure prudent debt management. So, you can’t rely on borrowing everything today that you might need to spread out over a 5/10/15 or even 30-year period. You’ve got to kind of read the room, speak to the audience. There are lots of pension funds that need to match their liabilities with assets and vice versa. And that’s why the Treasury spreads out its borrowing. So, treasury bills typically have a maturity of one year or less and they don’t pay interest before the expiration of the maturity period. A Treasury note typically has a maturity period of two to 10 years and they come in denominations of $1000 and offer coupon payments every six months. So, the most frequently cited debt instrument is the 10-year Treasury note, which is kind of a barometer for the performance of the bond market, it’s also used to show the markets take on macroeconomic expectations. Treasury bonds have the longest maturities among the three treasuries. They have a maturity period of between 20 and 30 years, typically with coupon payments again every six months. And T-bond offerings were suspended for years between February 2002 and February 2006, but then were resumed due to demand from pension funds and other longer term institutional investors.

Mary MacNamara

So, how do you compare the yields on the different treasuries?

Andrew Wilkinson

Well, this is a little bit like literally connecting the dots now Mary, because we’ll talk now about the US Treasury yield curve. The yield curve is a line that depicts the yields from short-term treasury bills right through to those longs, right through the Treasury notes at the 10-year right through to about 30 years. So, the chart shows the relationship between interest rates and maturities of U.S. Treasury fixed income securities. The Treasury yield curve is also referred to as the term structure of interest rates. Now, we can have different shapes for the yield curve. A normal yield curve shows lower yields for shorter maturity bonds, but then it increases for bonds with a longer maturity, sloping upwards. This curve indicates that yields on longer-term bonds are continuing to rise, responding to a period perhaps of economic expansion.

Mary MacNamara

So, what is yield curve risk? I’ve often heard that term used.

Andrew Wilkinson

So, yield curve risk refers to the risk investors of fixed income instruments such as bonds experienced from an adverse shift in interest rates. Interest rates move every day, and sometimes they can move sharply. Yield curve risk stems from the fact that bond prices and interest rates have that inverse relationship, that I mentioned earlier, to each other as the price of bonds decreases, market interest rates increase and vice versa. So, the yield curve provides an easy visual comparison.

Mary MacNamara

So, Andrew, how can investors use the yield curve?

Andrew Wilkinson

So, investors can use the yield curve Mary to make predictions about the economy in order to perhaps make investment positions. If the bond yield curve indicates an economic slowdown, investors might move their money into defensive assets that traditionally do well during a recession. If the yield curve becomes steep, this might signal future inflation, and in this scenario, investors might avoid long term bonds with a yield that will erode when faced with increasing inflation. So, let’s just recap. I mentioned that there are three shapes then to the yield curve, there’s a normal upward sloping curve and inverted downward sloping curve and then a flat curve. So, the slope of the yield curve predicts interest rate changes and the likely outcome of economic activities. So, investors can use the yield curve to make predictions about the economy and to make investment decisions. In most scenarios, the treasury yield curve is upward sloping. Investors typically then demand higher interest rates for tying their money up for longer term investments as compensation for investing their money in longer duration investments. Occasionally, longer term yields may fall below short-term yields creating what’s known as an inverted yield curve that is generally regarded as a harbinger of recession. And a flat, or a humped yield curve, means that short and long term yields are pretty much close to each other, relatively flat.

Mary MacNamara

So, I guess the next natural question would be, where is the yield curve today and what does it mean for us?

Andrew Wilkinson

So, fairly much for the duration of while the Fed has been putting up interest rates, the yield curve has become inverted and the reason is that investors often think that when interest rates go up, the Federal Reserve will over tighten monetary policy and push short term interest rates up so far that it causes the economy to cool, to squeeze inflation out of the system, and then that the next move will be a reduction in interest rates to counter a likely recession. However, while the yield curve has responded that way, that it’s become inverted, what investors are beginning to hear from the Fed is that they’re not going to cut interest rates anytime soon, and they’re talking about this higher for longer situation in which the Fed has not clearly finished raising interest rates, but it doesn’t appear to be in any kind of a rush to actually cut them. So, if the curve has flattened an awful lot, but it’s still inverted with the odds on that, there will be at some point a recession and that the Fed will ultimately cut interest rates, but nobody can really see with any clarity that that’s happening till at least the middle of 2024 or maybe even beyond.

Mary MacNamara

Well, that’s excellent, Andrew. Great explanation. I think I understand now more about T-bills and the treasuries and also this inverted yield curve because you hear that all the time when you’re watching the news. So, folks, thank you so much for joining us today. Don’t forget to check out our show notes. We’ll have a couple of charts that we brought up today and also a couple of links especially to that Treasury direct. Thank you so much, and everybody have a great day.