What it means
When a government needs to bridge the gap between tax receipts and spending during the year, it borrows for short periods by issuing bills. An investor might buy a bill with a face value of $1,000,000 for $990,000 and receive the full $1,000,000 in ninety-one days.
There is no coupon payment along the way, which is why these instruments are described as discount securities. The appeal is safety combined with liquidity.
A national government borrowing in its own currency is regarded as the closest thing to a risk-free borrower available, and the market for its short-dated bills is deep enough that large amounts can be sold in minutes at a fair price. That combination is why treasurers park operating cash in government paper rather than leaving it all on deposit at one bank.
Corporate treasurers use government paper as the foundation of a cash ladder, buying bills that mature on the dates the company expects to need money for payroll, tax or dividends. Money market funds hold it for the same reason, and banks hold it because regulators count it as high-quality liquid assets when testing whether a bank could survive a run.
Its yield is also the reference point for pricing almost everything else, because the risk-free rate sits at the base of most valuation models. The main risk is not default but price movement before maturity.
If market interest rates rise after you buy, the price of your bill falls and selling early would crystallise a loss, so the safe assumption is that you hold to maturity. There is also inflation risk, since a 4% return is a real loss if prices are rising at 5%.
Terminology varies by country and by maturity, which trips people up. Bills usually mean maturities of one year or less, notes cover the medium range, and bonds cover long maturities, while government paper as a phrase is normally reserved for the short end.
Related instruments such as inflation-linked bills or floating rate notes exist too, and they behave differently, so always check exactly which instrument is being discussed.
In practice
Real-world examples.
Example
A software company holds $40,000,000 of cash raised in a funding round and needs $10,000,000 each quarter. The treasurer buys four tranches of government paper maturing at three, six, nine and twelve months so cash arrives when it is needed rather than sitting in a current account earning nothing.
Example
A regional bank must hold high-quality liquid assets to satisfy its regulator. It keeps $250,000,000 in short-dated government bills because they can be sold or pledged for cash within a day even in stressed markets.
Example
A charitable foundation receives a large legacy in December but does not make grants until the following summer. The trustees place the money in six-month government paper so the capital is protected and the return is predictable.
Formula
Calculation
Annualised return = ((Face value - Purchase price) / Purchase price) x (365 / Days to maturity)
A corporate treasurer buys a 91-day Treasury bill with a face value of $1,000,000 for $990,000.
Discount earned = $1,000,000 - $990,000 = $10,000
Return over the holding period = $10,000 / $990,000 = 0.010101, or 1.0101%
Annualisation factor = 365 / 91 = 4.011
Annualised return = 1.0101% x 4.011 = 4.05%
So the treasurer earns $10,000 of income over three months, which is equivalent to about 4.05% a year. If the bill had cost $995,000 instead, the discount would be $5,000, the holding period return 0.5025%, and the annualised return roughly 2.02%, which shows how sensitive the yield is to a small change in purchase price.Case study
Seen in the real world.
Brightpath Logistics is an illustrative, fictional haulage company used to show the practical case for government paper. After selling a depot, Brightpath held $60,000,000 in a single business current account paying almost nothing, and the finance director worried about both the lost income and the concentration with one bank.
The board approved a simple policy: keep two months of operating costs in the bank and place the rest in a ladder of government bills. Brightpath bought $15,000,000 of paper maturing in each of the next four quarters. At an average annualised return of roughly 4%, the $45,000,000 invested generated about $1,800,000 of income over the year instead of near zero.
The fictional postscript matters as much as the return. When a supplier dispute forced an unexpected $12,000,000 payment, Brightpath sold part of one tranche the same morning at close to the price it expected, which is the kind of flexibility that longer or less liquid investments would not have offered.
Watch out
Common mistakes.
- Thinking government paper pays interest like a savings account. Most short-dated government bills pay nothing along the way and instead are bought below face value, so the return arrives entirely at maturity.
- Assuming it is risk-free in every sense. Default risk is minimal for a government borrowing in its own currency, but the price still moves with interest rates and the real return can be negative if inflation is high.
- Buying long maturities to chase a higher yield when the cash is needed soon. Matching maturity to the date the money is required is the whole point of a cash ladder.
Questions
People also ask.
How is government paper different from commercial paper?
Commercial paper is short-term debt issued by companies, so it carries credit risk and pays a higher yield; government paper is issued by the state and is treated as the benchmark for safety.
Can a small company buy it directly?
Usually it is easier to gain exposure through a money market fund or a bank's treasury desk, since direct auction participation is generally aimed at large institutions.
Why do yields sometimes go negative?
In periods of very loose monetary policy or extreme demand for safety, investors have occasionally paid more than face value simply to have somewhere secure to hold large sums.
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