With interest rates rising, Americans are flocking to US Treasuries at a record pace. Wondering if you should buy treasury bills or treasury bills in your portfolio? Here’s how a cash flow strategy can add value to your investments in certain situations and some caveats to consider.
How treasuries work
Treasury bills come in a some shapes: T-bills, notes, bonds are among the most common. Treasury bills mature in one year or less and notes between two and 10 years.
When you buy a government bond, assuming you hold it to maturity, you will get a guaranteed rate of return (yield to maturity). You know the yield to maturity before you buy the bond. The shortest US bonds, Treasury bills, are auctioned at a discount to face value (par). Invoices mature at par and do not earn interest.
Treasury bills and bonds pay interest every six months. They can be auctioned at a discount, a par, or even a premium depending on the terms of the bond (yield to maturity and interest rate).
When treasury bills are traded in the secondary market, prices depend on prevailing interest rates, rate expectations, coupon (interest) payments, etc. More on that later. But the point to remember is that whether you buy at the initial auction or in the secondary market, if you hold the bonds to maturity, your yield will be the stated yield to maturity (annualized) from procurement.
Create a cash ladder
Treasury bills can be attractive because investors rarely get a guaranteed return. Although not a long-term investment strategy or a way to build wealth, short-term government bonds have attractive use cases.
With rising interest rates, government bonds have become much more attractive to investors looking for a return on cash. The current rate on a two-year US Treasury note is 3.05%.¹ In comparison, Nerdwallet reports that the national average rate on a high-yield savings account is 0.70%. (Note: both numbers are annualized, so if you only hold six months, your real rate of return would be half).
With Treasury rates where they are, in some situations it might be worth considering buying some for your wallet as a cash holding. It is also possible to create an income stream by laddering treasury bills and notes.
With the latter, the investor would buy Treasury bills with different maturity dates. Maybe every six months, every year, or whatever suits your needs. By doing so, you can structure a ladder, where treasury bills automatically mature (at par) on a rolling basis. You can reinvest the money (at the prevailing interest rate) to maintain the interest rate, take the money to supplement income, or match debts to cover certain expenses, such as tuition.
As an added bonus, the interest on treasury bills is not subject to state taxes.
Guaranteed return? ! Why wouldn’t everyone buy treasury bonds?
Yes, assuming you think the probability of the US government defaulting is at or near zero and you hold to maturity, treasury bonds are a safe bet. That sounds good, and it is, but that doesn’t mean this approach makes sense for everyone.
Here are some reasons why
Selling early can result in a loss. The Treasury market is VERY liquid. So there’s little risk that you wouldn’t be able to sell a treasury bill before maturity if you wanted to. The question becomes, at what cost.
Interest rates and bond prices have a inverse relationship. So if interest rates go up, your bond is worth less (all other things being equal). Selling early can be done at a loss. Of course, it works both ways: if the Federal Reserve cuts interest rate, buyers will pay a premium for the outstanding bonds.
The time value of money. When considering a cash strategy, keep in mind the absolute dollars involved. As you are looking at an attractive yield to maturity, remember that a key assumption is that these funds are not available until maturity.
For example, suppose you buy a one-year treasury bill with a face value of $1 million and a yield to maturity of 2%. When the bill is due, your total dollar return is approximately $20,000. It’s certainly not a trivial amount of money, but does it adequately compensate you for a full year? Maybe yes, maybe no.
Use the correct comparison. Further to the point above, when considering Treasuries, especially shorter (2-3 year) notes and Treasuries, weigh the alternatives using the correct comparison. For example, suppose you have money in the bank that you are saving for a purchase in a year.
Your safe options are to put money in a high-yield savings account, a CD, or to buy a treasury bond. You will therefore compare the returns of cash and similar vehicles, including fixed yield to maturity on Treasury or CD and an APY High Yield Savings Account
But if you don’t need the money and are considering different investment options, the math changes dramatically. It would make no sense to try to compare Treasuries to the S&P 500.
Should You Buy Treasury Bonds?
Treasury bonds are liquid, safe and backed by the US government. And nowadays, investors can actually get a decent return on their investment. That’s the good news. But the bad news, and what any investor considering buying Treasuries should consider, is how prices may move before maturity. Year-to-date, the Bloomberg US Treasury Index is down nearly 9.3%.² Granted, bonds are having one of their worst years on record, but it bears repeating that good are not without risk if they are not held to maturity.
Overall, given the current rate environment, in the right situations, buying US Treasuries can make a lot of sense.