Many investors opt for government bonds to preserve their capital. Government bonds are all securities issued by a government (in our case the US) to pay for a debt.
Because of that, people consider them safe and secure compared to the volatile stocks issued by private companies. This article will teach you about T-bills in particular, the way the function, interest rates, benefits and of course, the risks associated with them.
What is a Treasury Bill?
Treasury bills (also known as T-bill), T-notes, T-bonds are all government bonds or debt obligation backed by the US Treasury Department. However, there are some differences in their maturity and the way they pay interest. T-bills have the shortest terms – less than a year. In contrast, T-notes have maturities ranging from 1 to 10 years. A typical T-bond offers the longest maturity – up to 30 years.
Since the focus of our article is on T-bills, we won’t discuss the other bonds in detail if not necessary.
An investor can buy T-bills only in 1,000$ denominations and the maximum value they can purchase is 5 million dollars. As I already said, they have different terms and people buy them at a discount rate determined at an auction. The maturities vary from several days to 52 weeks (a year). They pay interest when they mature and the longer the term, the higher the interest rate.
How to Buy a Treasury Bill
Now that you know some basic information on T-bills, you can learn about how to buy one. Nowadays, since they are only in an electronic form, most buyers prefer to buy bonds from online websites, such as TreasuryDirect. You can also, however, purchase T-bills through a broker, a bank or a dealer.
No matter where you buy the bonds from, the first thing that any investor goes through is the bidding process.
Here, you have two options – make competitive and non-competitive bidding. Most people, especially those who are not very experienced prefer non-competitive bidding. What is it?
At the auction, people will decide what the interest rate of the T-bills will be. When you make a non-competitive bid, you actually agree to the interest rate people have determined during the auction. Certainly, your bid will be accepted and paid in full. However, you will have no control over the interest rate. You will know it after the auction ends.
The Treasury Bidding Process
When you make a competitive bid, you actually say how much you want the interest rate to be during the bidding process. Experienced investors, large corporations and pros prefer this type of bidding since they are an active part of the auction by trying to determining the interest rate. Unlike non-competitive bids, you never know if your bid will be accepted. There are two situations:
1. The auction approves a higher or equal rate to yours. Then, they will accept your bid and the rate will be the one the auction has set. All the other bidders whose rates are lower or equal will receive the same offer. For example, 4 participants in the auction want a rate ranging from 1.12 to 1.28. The auction sets the rate at 1.28. All these four participants will have the same rate – 1.28.
2. The auction approves a lower interest rate than the one in your bid. Then, the auction will decline your offer. For example, 5 other participants want a rate of more than 1.28. The auction will reject their bids.
The bidding process will begin after the US Treasury has announced the T-bills auction. When the auction starts, all the participants can submit their offers until it closes. The closing time is different for competitive and non-competitive bids. The former usually closes an hour after the latter – for competitive it’s 1 pm EST and for non-competitive 12 pm.
Consider The Discount Rate
Actually, the process of biding determines the discount rate at which you and all the other investors will buy the treasury bills. It’s an average from all the competitive bids during the auction. The maximum amount of T-bills an investor can purchase during one auction is 5$ million if you have made non-competitive bidding.
If you make competitive bidding, you can buy up to 35% of the total amount of the initial offering. Competitive and non-competitive auctions are not the only ways to buy T-bills. You can also purchase them via bank or a broker on the secondary market.
T-Bills Interest Rates
Where can you find them? Of course, online you can check every day the interest rates on T-bills as well as in daily newspapers.
Since their terms are less than or a year, you can find T-bills under the discount rate. The “Yield” column shows how the different T-bills compare against each other when it comes to their interest rates.
Example of T-Bills
For the purpose of our example, I am going to take a 1,000$ T-bill at a 3% interest rate with a maturity of one year. The interest it earns is 30$ and it sells at a discount of 970$. We calculate the effective yield of the T-bill by dividing the interest (30) by the discount (970) and the result is 3.09%.
If the T-bill has a maturity of 6 months, then it gives 15$ in interest and sells at 985$. The effective yield, in this case, is 3.04% (15/985x 2 times).
Benefits And Risks of T-Bills
Benefits of T-Bills
Let’s look at the main benefit of T-bills.
Investors consider them a “risk-free” investment and the fact that the US Treasury Department backs them up proves the point to a certain extent. The interest rate risk is not that high. Due to their short terms, up to one year, T-bills are protected from this risk since they mature relatively soon in the future.
When interest rates hike, fixed-income investments, such as corporate bonds and preferred stocks, lose their value. In comparison, T-bills are much more resistant to those movements.
Investors have a guaranteed return on their investment in T-bills for the same reason as the first advantage.
Tax Free Options
They are a tax-free investment since by law state cannot tax government bonds. Therefore, T-bills are free from state and local taxes.
T-bills are very liquid assets and investors know that this is one of the most important characteristics of a safe and profitable investment. When the US government issues new treasury bills, there are primary dealers who must buy them and trade them on the secondary market. If you can sell it, it’s worth buying it!
You can have easy access and buy these assets using a broker or directly if go to the TreasuryDirect website. The discount rate at which you purchase them is determined at the auction.
Risks and Disadvantages of T-bills
Even though most investors consider those assets risk-free, this is not entirely true. There are always risks when we talk about investing. What are the main risks and disadvantages of T-bill?
Interest rate risk
Bonds are closely correlated with the movement in interest rates. The relation is not as strong as between corporate bonds and interest rates, but it can have an impact. Usually, when rates go up, bonds decline.
The returns on T-bills cannot reach the level of inflation. For example, this year it is close to 2.5% while T-bills (6-month maturity) returns are below 2%.
Even though these investment tools are quite safe and risk-free, their returns are relatively lower compared to other assets.
Because of their maturity, you might miss out on other, more lucrative, opportunities in the market. The term of treasury bills is relatively short (up to a year), yet for a year it might cost you tens if not hundreds of missed chances.
Overall, investing in T-bills is a nice way to diversify and strengthen your portfolio. The fact that the US government backs them up and issues them makes those assets almost free of risk and very attractive. On the downside, their offer a relatively low yield.