U.S. TREASURY BILLS

Popularly known as T-bills, U.S. Treasury bills are short-term debt securities issued by the U.S. Department of the Treasury. They generally come in three maturities: 13 weeks (also cited as three months or 91 days), 26 weeks (six months or 182 days), and 52 weeks (one year or 364 days). Along with other longer-term Treasury instruments such as U.S. Treasury notes (1- to 10-year maturities) and bonds (30-year maturities), T-bills are widely held, highly liquid, and low-risk investments. Most trading in T-bills, however, is done by institutional investors such as banks, brokerages, investment funds, and other types of firms.

Two markets exist for T-bills and other Treasury securities: the primary market and the secondary market. The primary market is through periodic auctions by the U.S. Treasury. They may then be resold any number of times on the secondary market, where they often serve as money market instruments, or short-term, low-risk, low-yield repositories for large sums of money. Interest earned on T-bills is tax-exempt at the state and local levels. Another attractive feature of T-bills is that they may be purchased in denominations as low as $10,000, which is considerably smaller than the minimum denominations of many other money market instruments, which may be $1 million or more apiece. This active secondary market ensures that Treasuries are highly liquid and flexible investments.

PRIMARY MARKET

The Treasury holds auctions for the 13-week and 26-week T-bills every Monday (or the next business day when the financial markets are closed on Monday). Auctions for the 52-week bill occur on Tuesdays every fourth week. Details on all upcoming auctions, including the total face value to be issued of each maturity, are announced weekly on Thursdays. New T-bills are actually issued a few days after the auction, typically on Thursdays.

Investors submit bids on either a competitive or noncompetitive basis. Competitive bidders state the price they are willing to pay, and noncompetitive bidders agree to accept the average price of all accepted bids. At the auction, the Treasury first accepts all noncompetitive bids, and then accepts competitive bids in descending order of price until the total face value of that maturity is sold. For example, if the Treasury wishes to issue $10 billion in 13-week bills and $6 billion in noncompetitive bids has been received, only the first $4 billion in competitive bids, beginning with the highest, will be accepted.

The price paid by the noncompetitive bidders is equal to the weighted average of the competitive bids; in the example, the weighted average bid for the $4 billion worth of bills. The results of each auction are summarized in the Wall Street Journal and on numerous Internet sites, including the Treasury's Web site.

T-bills are sold at a discount, and prices are quoted as a percentage of the maturity value. The discount is the difference between the face value and the purchase price, and represents the interest earned on the investment. Unlike Treasuries with longer maturities, T-bills don't pay periodic interest payments; the full value of the interest is factored into the discount and earned if the bill is held to maturity.

The discount rate, also called the discount yield, on T-bills is determined by the competitively determined purchase price and may be calculated using the bank-discount method as follows:

where r = discount rate
M = maturity (face) value
P = purchase (discount) value
D = days to maturity

For example, if the average purchase price at auction for a 13-week bill is $98.835 per $100 of par value, the discount yield would be found as follows:

However, for some purposes the discount rate is believed to underestimate the real return on investment because it is the rate of return on the face value of the bill, rather than the return on the amount actually invested (i.e., the purchase price). As an alternative, some prefer to calculate the investment rate as follows:

where r = investment rate
M = maturity (face) value
P = purchase (discount) value D = days to maturity

Note that the investment rate formula uses 365 days (or 366 in a leap year) instead of 360 (which is based on 12 30-day months) as the numerator over time to maturity. In the example above, the investment rate would be determined as follows:

Thus, the investment rate, also known as the equivalent coupon yield or the effective yield, tends to show a return that is 10 to 20 basis points higher than the discount yield indicates. Summary reports of Treasury auctions often show both the discount yield and the investment yield.

A quick estimation of a T-bill yield may be done by taking the discount value per $100 (so if the purchase price is $98.835, the discount is $1.165), and multiplying it by the number of maturities that make up a year for that kind of bill (e.g., there are four 13week and two 26-week maturities in a year). Hence, a rough estimate of the yield on the 13 week T-bill bought at $98.835 would be $1.165 × 4, or 4.66 percent. In this case, the estimate falls in between the calculated discount rate and the investment rate.

Money center banks, securities dealers, and other institutional investors submit the majority of competitive bids in T-bill auctions. Individuals may purchase new issues of T-bills in several ways: (1) from the Treasury's Bureau of Public Debt or one of the Federal Reserve Banks (a paper bid can be mailed); (2) over the phone or the Internet through the TreasuryDirect system; or (3) through a broker or bank.

SECONDARY MARKET

Government securities dealers are responsible for providing an active secondary market in all U.S. government securities, and especially in Treasury securities. The price at which dealers are willing to buy is called the bid price and the price at which they are willing to sell is called the asked price. The difference between these prices is called the spread, which is the dealer's compensation for brokering the transaction.

Secondary market trading of T-bills is typically reported in the financial news in terms of the discount rate bid and asked, instead of the purchase and selling prices per unit of face value, as is done in the primary market. For example, a secondary market listing may show that a T-bill with 30 days left to maturity was bid at 3.87 percent and asked at 3.83 percent. Both the bid and asked price are calculated using the bank-discount method given by

where P = purchase (discount) value
M = maturity (face) value
r = discount rate
D = days to maturity

In the example above, the bid price on a $10,000 T-bill with 30 days left to maturity would be

and the asked price would be

Since the spread is the asked price less the bid price, in this example the dealer's spread is $9,968.08 - $9,967.75, or a modest $0.33 per $10,000. Since the dealer is likely handling millions of dollars worth of T-bills, this would amount to a more substantial profit when the total value of the bills is considered. For the buyer who pays the asked price, the yield if held to maturity would be calculated by the investment return rate formula above, which would equal 3.896 percent. Financial papers typically publish this amount under the heading "ask yield" or something on that order.

In order for the dealer to have a positive spread, i.e., to make a profit, the asked price is always higher than the bid price. Because price and discount rate have an inverse relationship, this means the asked discount rate is always slightly lower than the bid rate, typically by just a few basis points. Spreads tend to be more narrow the longer the time left to maturity.