T-bills Explained | Your Guide to Treasury Bills

Financial Literacy

T-bills Explained | Your Guide to Treasury Bills

Find out what T-bills are and how they work.

This post may contain affiliate links and/or paid placement. Click here to read our full disclosure.

T-bills Explained | Your Guide to Treasury Bills

T-bills, or treasury bills, are short-term debt instruments issued by the U.S. Treasury with terms of one year or less. They offer a safe investment vehicle for those looking to diversify their portfolio and earn interest on their money while avoiding riskier assets like stocks and commodities. But before you invest in T-bills, it's important to understand how they work and if they're right for your portfolio.

This article will answer common questions about T-bills: What is a T-bill? How do T-bills work? Are T-bills a good investment? Read on to find the answers to these questions and more.

What Are T-Bills?

Treasury bills (or T-bills) are fixed income securities usually sold in denominations of $1,000 up to $5,000,000. The maturity period of T-bills ranges from a few weeks up to 52 weeks, so it's a short-term investment that doesn't lock up your money for a long period.

These securities are widely regarded as low-risk and secure investments because they're fully backed by the government. When you purchase a treasury bill, you're essentially loaning money to the government.

We're going to get into a little bit of the technical jargon here, but stick with me, it will make sense momentarily.

T-bills are sold at a discount from the par value or face value. The amount you pay is referred to as the discount rate. When the bill matures, you'll be paid its par value or face value. The difference between the par value and the discount rate that you paid is your interest or return on investment.

For example, the T-bill may have a par value or face value of $1,000, and you might pay $970 for it. Once it matures, you would be paid $1,000, which includes your $30 of interest.

The Treasury Department issues T-bills through an auction, using both competitive and non-competitive bidding processes. If they are sold through a non-competitive process, the price is based on the average of the competitive bids received.

The most common maturities are 4, 8, 13, 26, and 52 weeks. In general, treasury bills with longer maturity dates will offer the most interest for investors.

What Impacts T-Bill Prices?

Since T-bills are sold through an auction process, the price fluctuates. The par value or face value remains the same, but the discount value (what you pay) can go up or down based on several different factors. Of course, since the discount value fluctuates, that means your interest or return on investment will also fluctuate. Here are the primary factors that influence T-bill prices:

Maturity Date

One of the biggest factors that impacts price is the maturity date. Investors typically expect the highest interest rates or return on investment for longer investments. As a result, a T-bill with a one-year maturity period will typically offer the highest interest (lowest discount value).

Inflation

Inflation also impacts the price of treasury bills because investors will be hesitant to buy a T-bill if the interest is lower than the rate of inflation. For example, if inflation is currently at 4% and a T-bill is offering 2% interest, the investment will not be able to keep up with the rate of inflation.

As a result, demand for T-bills typically drops when inflation is rising. When demand drops, prices also drop.

Risk Tolerance

When other types of investments like stocks and ETFs are producing solid returns, demand for T-bills drops. Investors are likely to have a higher risk tolerance when these other types of investments are expected to perform well and offer a better ROI than T-bills.

However, when the stock market and other more aggressive investments are performing poorly, demand for conservative investments like T-bills will increase and prices will go up. As more people are looking for the safety and security offered by treasury bills, the return on investment will decrease due to the higher prices.

Monetary Policy

The federal funds rate set by the Federal Reserve also impacts the rates of T-bills. When the federal funds rate increases, investors tend to look for investments with higher yields, which leads to a decrease in demand and lower prices for T-bills.

When the federal funds rate is decreasing, demand for T-bills will increase, which leads to higher prices and lower returns on investment.

Liquidity

Treasury bills offer limited liquidity options for investors. Since the par value will not be paid until the date of maturity, they are generally not liquid assets or investments.

However, it's possible to sell T-bills on a secondary market, which allows you to liquidate the investment and turn it into cash before the maturity date. Of course, if you're selling a T-bill early, you shouldn't expect to get the full face value, which means your return on investment will be lower, and you may even lose money.

T-Bill Tax Considerations

The interest earned from treasury bills is subject to federal income tax (taxed as interest income), however, it is exempt from state and local income taxes. You can read more about the tax details at TreasuryDirect.

How to Purchase T-Bills

To buy T-bills, you simply need to set up an account at TreasuryDirect and fund it with a checking account. It's free to create an account, and this is where all of your T-bills will be stored until they reach maturity. When they do reach maturity, you can reinvest by using the proceeds for new T-bills or transfer the money back to your bank account.

Alternatively, some banks and brokers also sell treasury bills, so TreasuryDirect is not the only option.

The Benefits of T-Bills

Let's look at the benefits, or why you might want to buy treasury bills.

No Risk of Default

T-bills are backed by the United States government and are among the safest investment options out there. There is almost zero risk that you'll lose your initial investment. If your portfolio includes a lot of stocks, ETFs, or higher-risk investments, you may want to invest in T-bills for diversification and to provide added stability in case of financial turbulence.

Straightforward Investment That's Easy to Understand

Once you understand how T-bills work, it's a very straightforward investment. By simply reading this article, you'll know everything you need to understand to get started. Compare that to some other types of investments, like stocks or real estate, that can be much more complicated.

Low Minimum Investment Requirement

It's possible to buy treasury bills for as little as $100. Unlike some other investments, you don't need thousands of dollars or more to start investing.

Short-Term

Your money won't be locked up in T-bills for years to come. With maturities that range from a few days to one year, buying T-bills is a legit option when you're looking for a safe short-term investment that offers better returns than storing your money in a savings account.

Liquidity Offered Through the Secondary Market

Although you cannot redeem a T-bill until the maturity date, it's possible to sell it on the secondary market if you're in a situation where you need to liquidate. This is not an ideal option since it will negatively impact your return on investment, but it still gives you the possibility to liquidate at any time.

The Drawbacks of T-Bills

Of course, like any other investment or financial product, there are some cons or drawbacks that also need to be considered.

Low Returns

Compared to many other types of investments, the returns you'll get from T-bills are low. T-bills might be an option for a small part of your portfolio, but don't invest too much into T-bills if you want to maximize your returns.

No Interest Earned Until Maturity

Unlike some other investments that pay interest or dividends daily, monthly, or quarterly, you won't receive any interest with T-bills until the maturity date. Thankfully, you won't be waiting too long since it's a short-term investment. However, you may have to wait up to a full year to get the interest.

Hidden Risks

T-bills are considered a safe or conservative investment, but there are two risks you should consider:

Interest rate risk - If interest rates or inflation increases, your safe investment in T-bills becomes less attractive.

Opportunity cost - What else could you be doing with your money? When other investments are producing great returns, you'll be missing out on the opportunity for better returns if you're investing in T-bills.

Should I Buy T-Bills?

If you're looking to add a safe low-risk investment to your portfolio, T-bills may be the right option. However, you're investing for the long-term and you're willing to accept greater risk with the hope of producing better returns, T-bills may not be the right fit for you.

Final Thoughts

Whether you choose to invest in T-bills or not, it's helpful to understand what they are and how they work. When the situation arises where you're looking for a low-risk short-term investment, you may choose to consider treasury bills.

The opinions expressed in this article are for general information purposes only and are not intended to provide specific advice or recommendations about any investment product or security. This information is provided strictly as a means of education regarding the financial industry.

Financial LiteracyInvesting

Comments