The U.S. government has two primary methods of raising capital. One is by taxing individuals, businesses, trusts and estates; and the other is by issuing fixed-income securities that are backed by the full faith and credit of the U.S. Treasury. These securities come in three forms: bills, notes and bonds. Treasury Bills have the shortest maturity of the three, and their yield is widely considered to be the definitive risk-free rate of return by financial analysts and market technicians. Read on to find out how these short-term instruments can benefit your investment portfolio.
T-Bills have many of the same features as T-Notes and bonds. They are issued directly by the U.S. Treasury as a means of raising capital, and the return of their principal plus interest is guaranteed to investors regardless of what happens in the stock or bond markets. They can be purchased directly online at auction in increments of $100 (in maturity value). They are now only issued in electronic form, and paper certificates are no longer available. T-Bills also resemble zero-coupon bonds in that they are issued at a discount and mature at par value, with the difference between the purchase and sale prices representing the interest paid to the investor. The discount rate is calculated at the time of auction, and the interest on these securities is paid at maturity. T-Bills are issued in maturities of 4, 13, 26 and 52 weeks and can be purchased either directly online or through a bank or broker. T-Bills are auctioned every week, except for the 52-week Bill, which is auctioned every 4 weeks.
For example, a T-Bill with a maturity of 26 weeks might be issued at a value of 99.876 and mature at a value of $1,000 at maturity. Investors can submit two different types of bids for T-Bills:
- Competitive Bids – This type of bid sets a price limit on the amount that may be paid to purchase T-Bills. This type of bid limits the amount of discount that the investor is willing to accept on a purchase order. If the current discount rate is more than the rate that the investor is willing to accept, then the order is likely to be filled. If the discount rate equals the investor’s asking price, then the order may be partially or totally filled. If the discount rate is less than the rate that the investor is willing to accept, then the order will probably not be filled. This type of bid cannot be placed through Treasury Direct and can only be placed through a bank or broker.
- Noncompetitive Bids – This type of bid essentially equates to a market order. The investor is willing to accept whatever price, or amount of discount, that is currently built into the markets. Investors who want to be guaranteed that they can purchase a specific offering of T-Bills often enter this kind of bid to be assured that they will have their orders filled. This type of bid may be placed through Treasury Direct or a bank or broker.
Investors can buy up to $5 million of T-Bills in a single noncompetitive bid or 35% of the total amount of bills offered in a single auction.
Yield and Tax Treatment
The interest that is paid on T-bills is always taxable as ordinary income at the federal level, but never by states or localities. For this reason, the interest from these securities is attractive to conservative investors in states with high tax rates. Investors have the option of having up to half of the interest paid on their bills withheld for tax purposes.
The yields on T-Bills are always slightly lower than those of other comparable securities such as CDs. This is because of their perceived safety due to the direct governmental guarantee of interest and principal, regardless of whether this obligation can actually be met. Of course, the yield on a T-Bill rises as the time to maturity lengthens.
Investors with short-term time horizons can always turn to the laddering strategy to maximize their yields and minimize risk. This concept allows parcels of cash to become available at periodic intervals that can be reinvested at current market rates. Another conservative strategy is to invest the majority of a portfolio into T-Bills and then allocate a very small percentage into aggressive assets such as derivatives that could appreciate substantially in price if the markets move in the right direction. Of course, if the markets move in the opposite direction, the T-Bills will grow back to the original amount of principal at maturity. Or they may need to be reinvested a time or two, depending on the ratio of T-Bills to risky assets in the portfolio.
Of course, since the primary characteristic of T-Bills is that they offer a guaranteed return of principal, they typically function as the “safe” portion of an investment portfolio. They are often used in lieu of cash by knowledgeable investors who understand that they pay a higher rate of interest than cash instruments or accounts such as money market funds. This also makes them attractive for institutions bound by fiduciary requirements that prevent them from risking the principal of their funds in any way. However, T-Bills are still subject to both inflation risk and interest-rate risk, and investors who seek to outperform the markets over time should generally look elsewhere to fulfill their investment objectives.
The Bottom Line
T-Bills are useful tools for conservative investors who seek higher yields than what are available in cash accounts such as money market funds. Although they cannot grow faster than inflation over time, they do offer liquidity, safety of principal and exemption from state and local taxation.