There’s a lot of talk these days about US Treasury Bills, and a lot of folks don’t know what one is, or why they are important.
US Treasuries are certificates issued by the United States Government. Think of them as IOUs or loans. The government will issue Treasury Bills when they need to raise money they don’t have, usually to fund things like war, big spending projects or in recent times, pay their bills (I won’t get into why that is bad in this post). Treasuries can be bought by any person, or any country.
There are 3 important aspects related to a US Treasury; treasury price, maturity date, and yield (also called the interest rate). The easiest way to explain this is through a couple examples.
For simplicity sake, let’s say the government issues a 1-year Treasury Bill (maturity date) for $1000 (treasury price). That means the government will pay you $1000 one year after the treasury was issued. We know they will pay us back because their credit rating is excellent and they have never defaulted on a loan before, meaning, they have never failed to pay anyone back. Let’s say you bought the treasury for $950 dollars. After 1 year, the US Government will pay you $1000. That means, you made $50 dollars on you $950 investment. Another way of looking at it is, you lent the government $950 and they paid you $1000. That means you pocket about a 5.3% yield (interest rate) on your $950.
$1000 divided by $950 = 1.053 multiplied by 100 = 5.3%
As the demand for 1-year Treasury Bills increases, the treasury price will also increase. So, instead of paying $950 for the treasury, you may have to pay $970 to buy one. This being the case, and after 1-year, the government will again pay you $1000. This translates into about a 3.1% yield.
$1000 divided by $970 = 1.031 multiplied by 100 = 3.1%
The important thing to get from these two examples is, as treasury prices go up, yield prices go down. This is because the government will pay you $1,000 no matter what you bought it for, or who you bought it from.
As more people want to buy treasuries (increased demand), it costs more to buy the same $1000 treasury because there are fewer of them and people want to hang onto the ones they have. As the price goes up, the yield goes down because the difference between what you bought it for and the $1,000 the government will pay you back is less. When people don’t want to buy them (decreased demand), it costs less to buy the treasury and the yield goes up, because the difference between what you bought it for and the $1,000 the government will pay you back is greater.
Why buy a treasury? Well, there are two major reasons; a safe haven for your money, and a reliable known return on your investment. Once you buy a treasury, the yield is fixed so you know exactly how much money you will get in one year ($1,000). This is much different than a stock in which you have no idea how much it will be worth 1 day after you bought it, let alone 1 year.
Therefore, if you want a safe place to put your money, a treasury is a good option. That’s because the government has never defaulted on paying them back so you know you will get $1000 no matter what you bought it for. Other people will invest in treasuries when the price is low so they can get a good interest rate (yield) while also having their money invested in a safe place. It can get a little more complicated than this in that you can buy a treasury and then sell it whenever you want prior to the 1-year maturity date. So, say you buy it for $950 and two months later you sell it to someone else for $975. You just made a quick $25 on that treasury in only two months.
What’s the risk?
There really isn’t one except for one little thing called inflation. Say the yearly inflation rate is 3.0%, meaning something that costs $970 will cost $1,000 one year later ($970 x 3% = $1,000). If you bought a $1,000 Treasury Bill that also has a yield of 3.0% (you bought it for $970 and the government paid you $1,000 when it matured), you will have kept pace with inflation. Therefore, in relative terms, you didn’t really increase your wealth at all.
And here’s the consequence of the government issuing too many Treasuries…
If the US Government issues too many treasuries (meaning they want to borrow a lot of money), they will flood the market and there may not be enough people who want to buy them. They might be afraid the government won’t be able to pay them back, or people just don’t want them because inflation is increasing at a greater pace than the yield on the Treasury Bill. When this happens, the price of the $1,000 Treasury Bill will drop. As the price drops, the yield goes up. This is bad for the government because they get less money from you for the treasury, but still have to pay you $1,000 at the end of 1-year. For example:
US Government would like to borrow $10,000
They issue 10 Treasuries at $1,000 (10 x $1,000 = $10,000 is what they must pay back)
At $950, the government sells them for $9,500 (10 x $950 = $9,500)
They lose $500.
At $980, the government sells them for $9,800 (10 x $980 = $9,800)
They lose $200.
That’s a difference of $300 for those 10 Treasury Bills.
While this may not sound like a lot based on this example, you have to remember the government is issuing tens of millions of these $1,000 Treasury Bills. If they can’t sell them at $980 and instead have to sell them at $950, that can be the difference of $30,000,000,000. That’s 30 billion dollars!