What is the Treasury Yield
Treasury yield is the return on investment, expressed as a percentage, on the U.S. government's debt obligations. Looked at another way, the Treasury yield is the interest rate that the U.S. government pays to borrow money for different lengths of time.
Treasury yields don't just influence how much the government pays to borrow and how much investors earn by investing in this debt, they also influence the interest rates that individuals and businesses pay to borrow money to buy real estate, vehicles and equipment. Treasury yields also tell us how investors feel about the economy. The higher the yields on 10-, 20- and 30-year Treasuries, the better the economic outlook.
Understanding Treasury Yield
BREAKING DOWN Treasury Yield
When the U.S. government needs to raise capital to source projects, such as building new infrastructure, it issues debt instruments through the U.S. Treasury. The types of debt instruments that the government issues include Treasury bills (T-bills), Treasury notes (T-notes) and Treasury bonds (T-bonds), which come in different maturities up to 30 years. The T-bills are short-term bonds that mature within a year, the T-notes have maturity dates of ten years or less and the T-bonds are long-term bonds that offer maturities of 20 and 30 years.
Factors That Drive the Treasury Yield
Treasuries are considered to be a low-risk investment because they are backed by the full faith and credit of the U.S. government. Investors that purchase these Treasuries loan the government money. The government, in turn, makes interest payments to these bondholders as compensation for the loan provided. The interest payment, known as coupons, represents the cost of borrowing to the government. The rate of return or yield required by investors for loaning their money to the government is determined by supply and demand.
Treasuries are issued with a face value and a fixed interest rate and are sold at the initial auction or in the secondary market to the highest bidder. When there is a lot of demand for the securities, the price is bid up past its face value and trades at a premium. This lowers the yield that the investor will get since the government only repays the face value on the maturity date. For example, an investor that purchases a bond for $10,090 will be repaid only the face value of $10,000 when it matures. When the Treasury yield falls, lending rates for consumers and businesses also fall.
If the demand for treasuries is low, the Treasury yield increases to compensate for the lower demand. When demand is low, investors are only willing to pay an amount below par value. This increases the yield for the investor since he can purchase the bond at a discount and be repaid the full face value on the maturity date. When Treasury yield increases, interest rates in the economy also increase since the government must pay higher interest rates to attract more buyers in future auctions.
Treasury yields can go up if the Federal Reserve increases its target for the federal funds rate (in other words, if it tightens monetary policy), or even if investors merely expect the fed funds rate to go up.
Each of the Treasury securities has a different yield. Under normal circumstances, longer-term Treasury securities have a higher yield than shorter-term Treasury securities. Since the maturities on T-bills are very short, they typically offer the lowest yield compared to the T-notes and T-bonds. As of November 29, 2017, the Treasury yield on a 3-month T-bill is 1.28%; 10-year note is 2.39% and 30-year bond is 2.82%. The U.S. Treasury publishes the yields for all of these securities daily on its website.
Yield on Treasury Bills
While Treasury notes and bonds offer coupon payments to bondholders, the T-bill is similar to a zero-coupon bond that has no interest payments, but is issued at a discount to par. An investor purchases the bill at a weekly auction at less than face value and redeems it at maturity for face value. In this case, the difference between the auction price and face value is the interest which can be used to calculate the Treasury yield. The Treasury Department uses two methods to calculate the yield on T-bills with maturities of less than a year - the discount method and the investment method.
Under the discount yield method, the return as a percent of the face value, not the purchase value, is calculated. For example, an investor that purchases a 91-day T-bill for $9,800 per $10,000 face value will have a yield of:
Discount Yield = [($10,000 - $9,800) / $10,000] x (360/91) = 7.91%
Under the investment yield method, the Treasury yield is calculated as a percent of the purchase price, not the face value. Following our example above, the yield under this method is:
Investment Yield = [($10,000 - $9,800) / $9,800] x (365/91) = 8.19%
Note that the number of days per year used under both methods is different. The discount method uses 360, which is the number of days used by banks to determine short-term interest rates. The investment yield uses the number of days of a calendar year, which is 365 or 366. Given that the purchase price of a Treasury bill is always less than the face value, the discount method tends to understate the yield.
Yield on Treasury Notes and Bonds
The rate of return for investors holding Treasury notes and Treasury bonds includes the coupon payments that they receive semi-annually and the face value of the bond that they are repaid at maturity. T-notes and bonds can be purchased at par, at a discount, or at a premium, depending on the demand and supply of these securities at auction or in the secondary markets. If a Treasury is purchased at par, then its yield equals its coupon rate; if at a discount, yield will be higher than coupon rate and yield will be lower than coupon rate if purchased at a premium.
The formula for calculating the Treasury yield on notes and bonds held to maturity is:
Treasury Yield = [C + ((FV - PP) / T)] ÷ [(FV + PP)/2]
where C= coupon rate
FV = face value
PP = purchase price
T = time to maturity
The yield on a 10-year note with 3% coupon purchased at a premium for $10,300 and held to maturity is:
Treasury Yield = [$300 + (($10,000 - $10,300) / 10)] ÷ [($10,000 + $10,300)/2]
= $270 / $10,150 = 2.66%
Because of their low risk, Treasuries have a low return compared to many other investments. Very low Treasury yields like the ones observed from 2009 through 2013 can drive investors into riskier investments, such as stocks, which have higher returns.