What it means
As a department, the Treasury collects revenue through the Internal Revenue Service, pays the government's bills, prints currency and manages the nation's debt. When the government spends more than it collects, the Treasury borrows the difference by auctioning securities to investors.
These auctions happen on a regular schedule and are open to banks, funds, companies and individuals. The securities are grouped by how long they last.
Treasury bills mature in a year or less and are sold at a discount, notes run from two to ten years and pay interest every six months, and bonds run for 20 or 30 years. There are also inflation-protected securities and floating rate notes, whose payments adjust with prices or short-term interest rates.
Because the government has never failed to pay its debts, Treasury yields, the annual return an investor earns, are used as the risk-free rate in finance. Every other borrower, from a large corporation to a small business with a bank loan, is priced at a spread above the Treasury yield of a similar maturity.
When Treasury yields rise, borrowing across the economy generally becomes more expensive. Companies use Treasuries in several ways.
Corporate treasurers park spare cash in short-dated bills, banks hold them to meet liquidity requirements, and analysts use the yield on the ten-year note as an input when valuing businesses. Pension funds and insurers hold longer bonds to match their long-term obligations.
For a non-finance manager, the main message is that headlines about Treasury yields matter to the business even if it never buys one. They influence the cost of loans, the discount rates used to evaluate projects and the exchange rate of the dollar.
Watching the direction of yields helps a team plan funding and timing of large purchases. Auctions are the heart of how the Treasury sells its debt.
Bidders submit offers, and the securities are allocated to those willing to accept the lowest yield. The result of each auction is watched as a signal of how much demand there is for safe dollar assets.
In practice
Real-world examples.
Example
A software company has $3,000,000 of spare cash it will need for a payroll and tax payment in four months. Its treasurer buys four-month Treasury bills, which are safe and mature just before the payment is due.
Example
A bank examines how much cash-like assets it holds to meet regulatory liquidity rules. It keeps a large pool of Treasury securities because they can be sold quickly even in stressed markets.
Example
A valuation analyst values a small manufacturer and starts from the ten-year Treasury yield as the risk-free rate. She adds a premium for the risk of the business and arrives at a discount rate for the company's cash flows.
Formula
Calculation
Treasury bill price = face value x (1 - discount rate x days to maturity / 360)
Suppose a company buys a Treasury bill with a face value of $1,000,000 and 90 days left to maturity, at a discount rate of 4%. The price is 1,000,000 x (1 - 0.04 x 90 / 360) = 1,000,000 x (1 - 0.01) = 1,000,000 x 0.99 = $990,000. At maturity the Treasury pays $1,000,000, so the company earns $10,000 over 90 days on its $990,000 outlay.Case study
Seen in the real world.
Fenwick Logistics is an illustrative, fictional freight company with $8,000,000 in cash during a quiet season. The finance director would normally leave it in the operating account, which earns almost nothing.
Instead she builds a ladder of Treasury bills maturing monthly over the next six months, matched to expected large payments for fuel and equipment. Each bill matures just before the cash is needed, so no money is stuck when a bill is wanted.
In this illustrative story the ladder earns tens of thousands of dollars more than the operating account over the six months, with no risk to the principal. The director learns that safe does not have to mean idle.
Watch out
Common mistakes.
- Believing Treasuries carry no risk at all, when their market price falls if interest rates rise and the investor sells before maturity.
- Mixing up the discount rate on a bill with its actual yield, which is higher because it is based on the lower purchase price.
- Treating Treasury yields as a distant market matter, when they set the baseline for the cost of nearly all borrowing.
Questions
People also ask.
What is the difference between a bill, a note and a bond?
The difference is the time to maturity: bills run for a year or less, notes from two to ten years and bonds for 20 or 30 years.
Who can buy Treasury securities?
Individuals, companies, banks and foreign governments can all buy them, either at auction or later in the market.
Why are Treasury yields called the risk-free rate?
Because the government has the power to tax and issue currency, so investors treat the chance of default as the lowest available.
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