What it means
Treasuries are seen as having very low credit risk, so their yields serve as a base from which other rates are built. A treasury index turns that base into a number that can be published, tracked and written into contracts.
In lending, an adjustable-rate loan resets its interest rate at set intervals. The new rate equals the index at the reset date plus a fixed margin, and the index might be a constant-maturity Treasury yield, which is an average yield for a Treasury with a fixed term such as one year.
In investing, bond indices record the total return of a group of Treasury securities. A fund manager can compare a portfolio against such an index to see whether it earned more or less than the market, and some funds copy the index to match its returns.
Different indices cover different maturities. A short-term index follows bills and notes that mature in a year or two, while a long-term index covers bonds of 20 years or more, and the two can behave differently when interest rates change.
For a borrower, the practical issue is how much the loan payment could change. Loans usually include caps that limit how far the rate can rise at each reset and over the life of the loan, but the index still determines the direction of the payment.
For a business reader, the key point is that a treasury index is a reference, not a price anyone pays. The actual rate is built from the index, a margin and the lender's own terms, so two loans on the same index can still cost different amounts.
Always ask the lender for the margin, the caps and the reset schedule in writing.
In practice
Real-world examples.
Example
A family takes out an adjustable-rate mortgage tied to a one-year Treasury index. After the first fixed period, the rate resets by adding the lender's margin to the latest index value. The lender sends a notice a few weeks before the new payment starts.
Example
A pension fund measures its government bond portfolio against a Treasury index. The index returned 3.2% for the year, and the fund's portfolio returned 3.5%, so the manager beat the benchmark by 0.3 percentage points. The board uses this comparison to judge whether the fees paid to the manager are justified.
Example
A commercial lender prices a floating-rate loan to a property company as a Treasury index plus a margin of 3 percentage points. The loan agreement states which index applies and what happens if the index is discontinued. The borrower's lawyer checks that the fallback wording is clear before the deal is signed.
Formula
Calculation
For an adjustable-rate loan, the rate at each reset is:
New rate = Treasury index value + Margin
Assume an illustrative loan of $300,000 uses a one-year Treasury index, with a margin of 2.5 percentage points. If the index stands at 4.0% on the reset date, the new rate is 4.0% + 2.5% = 6.5%. Annual interest on $300,000 at 6.5% is $300,000 x 0.065 = $19,500, or $1,625 a month. If the index rises to 5.0%, the rate becomes 7.5%, and interest becomes $22,500 a year, which is $3,000 more.Case study
Seen in the real world.
Elmstead Dairy Cooperative is an illustrative, fictional business that borrowed $2,400,000 on an adjustable-rate loan tied to a Treasury index plus a 2% margin. When the loan was signed, the index was low and the monthly payments looked comfortable.
Eighteen months later, the index had risen by 2 percentage points, and the loan reset to a noticeably higher rate. The cooperative's interest cost rose by about $48,000 a year, a figure the finance manager worked out with $2,400,000 x 0.02, and cash flow became tight during the winter.
The board asked the bank to fix the rate on half the loan and bought an interest rate cap on the rest. In this illustrative case the new arrangement cost a modest fee, but it made the interest bill predictable and allowed the cooperative to plan its investment budget.
Watch out
Common mistakes.
- Assuming the index is the interest rate, when the rate also includes a margin and may be limited by caps.
- Ignoring what happens if the index is discontinued, since the loan terms should name a replacement.
- Comparing loans on different indices without looking at the margins, which can make a cheaper-looking loan more expensive.
Questions
People also ask.
What is a constant-maturity Treasury?
It is an average yield for a Treasury security with a fixed term, calculated from market yields so that it can be used as a reference rate.
Is a treasury index the same as the Treasury yield?
Not exactly, because a yield is one security's return, while an index may average, group or track many securities or maturities.
Can the index move down as well as up?
Yes, and when it does the rate on an adjustable loan can fall at the next reset, subject to any floor in the contract. Some lenders set a floor so that the rate cannot drop below a stated level.
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