A:

The reason that commercial bills have higher yields than T-bills is due to the varying credit quality of each bill type. The credit rating of the entity issuing the bill gives investors an idea of the likelihood that they will be paid back in full. The federal government's debt (T-bills) is considered to have the highest credit rating in the market because of its size and ability to raise funds through taxes. On the other hand, a company that issues commercial bills does not have the same ability to generate cash inflow because it does not have the same power over consumers that a government has over its electorate. In other words, commercial bills and T-bills differ in the credit quality of the bodies that issue them. A higher yield acts as compensation for investors who choose the higher-risk commercial bills.

For example, imagine that you have a choice between two three-month bills, both of which yield 5%. The first bill is offered by a small biotech company and the other is a U.S. government T-bill. Which bill is the wisest choice? In this case, any rational investor will probably choose the T-bill over that offered by the biotech company because it is far more likely that the U.S. government will pay back its debt when compared to a far less stable, much smaller entity like the biotech firm. If, on the other hand, the biotech bills are yielding 15%, the decision becomes more complex. In order to make a decision, an investor would need to factor in the likelihood that the small company could pay its debt as well as the amount of risk he or she is willing to take on.

In general, when there are two bills with the same maturity, the bill that has the lower credit quality or rating will offer a higher yield to investors because there is a greater chance that the creditor will be unable to meet its debt obligation.

To learn more, check out the Bond Basics Tutorial.

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