When we talk about a Treasury Bill, we are talking about a debt instrument issued and backed by the full faith of the US Federal Government.
T-Bills all mature in one year or less, and typical maturity increments are one month, three months, six months, and one year. Further, T-Bills are zero coupon instruments. Instead of paying periodic coupons, T-Bills are priced at a discount to face value, meaning investors pay a lower price now than what they will receive at maturity. These short maturity dates and the zero-coupon structure leave a few things to consider when one sees the headline yield.
Annualization is an important concept here.
When we say we can invest in a 6-month T-Bill at a 5% yield, the investor will not receive 5% more than they invested at the end of six months. In fact, 5% is what the investor will receive if and only if they can reinvest the proceeds of the original investment at the same rate for the same amount of time. Ergo, at the end of the year, it is possible the investor will receive 5% in yield; however, buying a 6-month T-Bill at 5% will not guarantee 5%.
Let’s take it further with an example.
At this writing, the 6-month T-Bill is yielding 4.88%. Since it does not pay a coupon, the investor will pay $976.45 for it and receive $1000 at the end of six months. This means the investor will have earned $23.55 over the six-month period, resulting in a six-month yield of 2.41%. Now the investor has $1000 to invest for the rest of the year. During this time, the 6-month T-Bill rate could have gone up, down, or stayed the same. Let’s say the rate stayed the same. That means the bill is still yielding 4.88% and the price is still $976.45. However, simply doubling the previous six-month yield of 2.41% results in 4.82% – less than the quoted 4.88%. This happens because T-Bills are always priced at a discount; it is impossible to reinvest the entirety of the previous period’s cash return. This same logic applies if the rate has moved. If the rate moved lower, the investor will not reach the original headline yield since the proceeds from the original investment are reinvested at a lower rate. If the rate moved higher, it is possible the investor will receive the original headline yield but it’s important to note that the investor will not receive the new, higher headline yield – it will be an average of the two six-month holding period returns.
Short-term treasury rates are higher in the current environment relative to the last few years. However, we believe in a measured fixed income approach. This means we typically invest a portion of our portfolios in the corporate market as well as look to invest in a variety of maturity structures from the very short to the more intermediate or longer-term.
things can change very fast in this market. When they do, investors who own debt instruments in a variety of maturity structures will have locked in the current environment’s higher rates for a longer period than those who had all their eggs in a 6-month basket.