How Do Interest Rates Affect Treasury Bills?

Written by

Meow Advisory, LLC

Published on

Wednesday, January 3, 2024

How Do Interest Rates Affect Treasury Bills?

Treasury bills (T-bills) are short-term debt securities issued by the U.S. government with maturities less than one year. They are considered among the safest investments since they are backed by the full faith and credit of the U.S. government.

What Factors Influence Treasury Bill Rates

Several key factors impact Treasury bill rates:

  • Supply and Demand - When demand for T-bills increases, prices rise and yields fall. Conversely, an increase in T-bill supply without a matching rise in demand will cause prices to drop and yields to increase. Global events that spur a "flight to safety" often increase demand.
  • Federal Reserve Actions - As the nation's central bank, the Fed directly controls short-term interest rates like the Fed Funds rate. Rate hikes trickle down to affect yields on T-bills and other money market securities. Traders anticipate Fed moves well in advance.
  • Economic Conditions - Rates typically rise during economic expansions as inflation picks up, while recessions see falling rates. The overall economy also impacts risk appetite, with investors fleeing to "safe haven" T-bills in downturns.
  • Inflation Expectations - Inflation erodes purchasing power and the "real" returns of fixed income. Higher inflation drives rates up across bond markets, including short-term T-bills.

How Rising Rates Impact Treasury Bills

As interest rates climb, T-bill prices fall to offer competitive yields. There is generally an inverse relationship between bond prices and yields.

  • Falling Prices - The impact of rising rates depends partly on the T-bill's duration, a measure of price sensitivity. Longer-dated T-bills tend to see greater declines. Across maturities, prices drop to keep yields competitive.
  • Less Demand - Alternatives like certificates of deposit (CDs) and high-yield savings may offer higher nominal returns when rates rise across the board. Conservative investors accept lower real yields from T-bills for their safety.
  • Underperformance - While T-bills are nearly default-risk free, they can lose out significantly to other bonds in rising rate environments. Investors expect some capital loss in exchange for their guarantees.

Comparing T-Bills to Other Bonds

It helps to understand where T-bills fit relative to similar fixed income products.

  • Treasury Notes and Bonds - The main differences lie in the term to maturity, with bills less than a year while notes run up to 10 years and bonds reach 30 years. Notes and bonds also pay periodic coupons.
  • Corporate Bonds - T-bills provide the safety of direct U.S. government obligations. In exchange for higher yields, corporate bonds come with default risk and are more vulnerable to market swings.
  • Municipal Bonds - "Munis" offer income tax exemptions in some states, but yields are lower than corporate bonds while risk is higher versus T-bills.

When Do Treasury Bills Make Sense?

While rising rates hamper demand, T-bills have portfolio merits for certain investors.

  • Favor Safety - Conservative investors and those near or in retirement may opt for T-bills to preserve capital, accepting meager real returns. Cash equivalents provide stability.
  • Temporary Holdings - When yields drop, investors may "park" money in T-bills while waiting to shift into better-yielding securities at opportune times. T-bills offer temporary respite.
  • Collateralization - Financial firms use T-bills as low-risk collateral and liquid holdings, given their short durations and the ability to easily sell or repo securities.

Key Takeaways

T-bill rates track closely with Fed policy and inflation expectations. While guaranteed in principle, T-bills can still lose value and appeal when interest rates climb. Alternatives include CDs and high-yield savings for conservative investors. Overall, the safety and stability of T-bills must be weighed against lower nominal returns and inflation risk.

How to Purchase Treasury Bills

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