What are Treasury Bills And How You Can Use It?

I got this email from Philips Capital and I just re-post it here. I believe some of you might have received this email as well. Before you are in a hurry to delete it, let’s spend some times to see how it can benefit us? Well, at this period of time where we are unsure which way the market is heading to, though it seems we are most likely to head towards a soft economy; this might be a good alternative fixed income investment for risk adverse investors.

Singapore Government Securities (SGS) Treasury bills (T-bills) are short-term debt securities that are issued by the Singapore Government. The tenors for Treasury bills range from as short as 7 days up to 1 year.

Treasury bills are a very useful and low risk investment tool that everyone should take advantage of.

How you can make use of Treasury bills?

Given the current yield of 1.52% p.a. (Rate is based on a 3 month T-bill and is accurate as of 23 Jan 2008.) for a 3 month T-bill, it is definitely much better than the interest given by normal saving deposits (Based on rates of UOB Passbook Saving Account, OCBC Passbook Saving Account, and DBS Auto-save (Personal) Account. Rates are taken from respective websites and accurate as of 16 Jan 2008.).

Given the flexibility of selling away your T-bills at any time, you will be able to liquidate your investment when you need the money. You can even choose to liquidate just part of it (in multiples of 1000 units).

While some fixed deposits might be offering a higher interest as a promotion, they usually require you to lock up your deposit for the entire tenure, and require a minimum investment of quite a significant sum. Unlike them, T-bills only require a minimum investment of less than $1000. If you are unwilling to lock-up a huge chunk of your funds in fixed deposits, T-bills will be suitable for you.

For equities investors, you can make use of T-bills as well. During occasions where you are staying at the sidelines, waiting for the next opportunity to make a killing, you can park your spare cash in T-bills to earn some interest. Make your money work harder for you.

How Treasury bills work?

Treasury bills have a fixed maturity date and have zero coupons. This simply means that during the tenor, the owner of the Treasury bill will not be receiving any interest payments. Instead the Treasury bills are sold at a discount and redeemed at par value upon maturity. That is why Treasury bills are also known as pure discount investment instrument.

Suppose you purchase 1000 units of a 1-year T-bill at a yield of 2%.
You will only need to pay $980 and you will receive $1000 upon maturity a year later.

Similarly for 1000 units of a 3-month T-bill at a yield of 2%, you will only need to pay $995 and you will receive $1000 upon maturity 3 months later.

To find out more on how you can start investing in Treasury bills, please visit here, email dcm@phillip.com.sg or call 6531 1555.

By the way, I do not get any benefits from Philips Capital for helping them to post this here in my blog. I just find this could be an alternative means of fixed income investment to grow your money, at least at this period of time when market is going up and down like a rollercoaster.

What are Treasury securities?

If you are new to the finance world and you have heard people saying things like T-Bonds, T-Notes or take the risk free rate as the 3-months T-Bills rate etc., you might be wondering what those things are. What exactly are Treasury securities?

Treasury securities (Treasuries) are issued by the U.S. Treasury. Because they are backed by the full faith and credit of the U.S. government, they are considered to be free from credit risk (though they're still subject to interest rate/price risk). The Treasury issues three distinct types of securities: bills, notes and bonds, and inflation-protected securities.

Treasury bills (T-bills) have maturities of less than one year and do not make explicit interest payments, paying only the face (par) value at the maturity date. T-bills are sold at a discount to par value and interest is received when the par value is paid at maturity (like zero-coupon bonds). The interest on T-bills is sometimes called implicit interest since the interest (difference between the purchase price and the par value) is not made in a separate "explicit" payment, as it is on bonds and notes. Securities of this type are known as pure discount securities.

• There are three maturity cycles: 28, 91, and 182 days, adjustable by one day (up or down) due to holidays. They are also known as 4-week, 3-month, and 6-month T-bills, respectively.
• Periodically, the Treasury also issues cash management bills with maturities ranging from a few days to six months to help overcome temporary cash shortages prior to the quarterly receipt of tax payments.

Treasury notes and Treasury bonds pay semiannual coupon interest at a rate that is fixed at issuance. Notes have original maturities of 2, 3, 5, and 10 years. Bonds have original maturities of 20 or 30 years. Although many bonds are still outstanding and still traded, the Treasury is not currently issuing new bonds.

Prior to 1984, some Treasury bonds were issued that are callable at par five years prior to maturity. The Treasury has not issued callable bonds since 1984.

Treasury bond and note prices in the secondary market are: quoted in percent and 32nds of 1% of face value. A quote of 102-5 (sometimes 102:5) is 102% plus 5/32% of par, which for a $100,000 face value T-bond, translates to a price of $102,156.25.

Since 1997, the Treasury has issued Treasury Inflation-Protected Securities (TIPS). Currently, only notes are offered but some inflation-protected 20- and 30-year bonds were previously issued and trade in the secondary market. The details of how TIPS work are as follow:

• TIPS make semiannual coupon interest payments at a rate fixed at issuance, just like notes and bonds.
• The par value of TIPS begins at $1,000 and is adjusted semiannually for changes in the Consumer Price Index (CPI). Even if there is deflation (falling price levels), the par value can never be adjusted to below $1,000. The fixed coupon rate is paid semiannually as a percentage of the inflation adjusted par value.
• Any increase in the par value from the inflation adjustment is taxed as income in the year of the adjustment: TIPS coupon payment = inflation-adjusted par value multiply by 0.5 multiply by stated coupon rate.

Treasury issues are divided into two categories based on their vintage:

• On-the-run issues are the most recently auctioned Treasury issues.
• Off-the-run issues are older issues that have been replaced (as the most traded issue) by a more recently auctioned issue. Issues replaced by several more recent issues are known as well off-the-run issues.

The distinction is that the on-the-run issues are more actively traded and therefore more liquid than off-the-run issues. Market prices of on-the-run issues provide better information about current market yields.

Since the US Treasury does not issue zero-coupon notes and bonds, investment bankers began stripping the coupons from Treasuries to create zero-coupon securities of various maturities to meet investor demand. These securities are termed stripped Treasuries or Treasury strips. In 1985, the Treasury introduced the Separate Trading of Registered Interest and Principal Securities (STRIPS) program. Under this program, the Treasury issues coupon bearing notes and bonds as it normally does, but then it allows certain government securities dealers to buy large amounts of these issues, strip the coupons from the principal, repackage the cash flows, and sell them separately as zero-coupon bonds, at discounts to par value.

For example, a 15-year T-note has 30 coupons and one principal payment; these 31 cash flows can be repackaged and sold as 31 different zero-coupon securities. The stripped securities (Treasury strips) are divided into two groups:

• Coupon strips (denoted as ci) refers to strips created from coupon payments stripped from the original security.
• A principal strip refers to bond and note principal payments with the coupons stripped off. Those derived from stripped bonds are denoted bp and those from stripped notes np.

STRIPS are taxed by the IRS on their implicit interest (movement toward par value), which, for fully taxable investors, results in negative cash flows in years prior to maturity. The Treasury STRIPS program also created a procedure for reconstituting Treasury notes and bonds from the individual pieces allowing arbitraging opportunities.

That is a very brief introduction to the Treasury securities. Hope the introduction clarifies some doubts you may have. Cheers.

Yield Curve for Bonds

For those students who graduated from WA07 class, if you still remember Conrad mentioned about the Inverted Yield Curves for year 2006 and 2007 and their implication to the economy, you may be wondering what Conrad is trying to get across to us. I'll try to explain what causes the shape of the yield curve in this post.

There are three theories to describe the term structure of interest rates that affect the shape of the yield curve. They are

1. Pure Expectation Theory
2. Liquidity Preference Theory
3. Market Segmentation Theory

So what does each theory say? The pure expectations theory states that the yield for a particular maturity is an average (not a simple average) of the short term rates that are expected in the future. If short term rates are expected to rise in the future, interest rate yields on longer maturities will be higher than those on shorter maturities, and the yield curve will be upward sloping. If short term rates are expected to fall over time, longer maturity bonds will be offered at lower yields.

Proponents of the liquidity preference theory believe that, in addition to expectations about future short term rates, investors require a risk premium for holding longer term bonds. This is consistent with the fact that interest rate risk is greater for longer maturity bonds.

Under this theory, the size of the liquidity premium will depend on how much additional compensation investors require to induce them to take on the greater risk of longer maturity bonds or, alternatively, how strong their preference for the greater liquidity of shorter term debt is.

The market segmentation theory is based on the idea that investors and borrowers have preferences for different maturity ranges. Under this theory, the supply of bonds (desire to borrow) and the demand for bonds (desire to lend) determine equilibrium yields for the various maturity ranges. Institutional investors may have strong preferences for maturity ranges that closely match their liabilities. Life insurers and pension funds may prefer long maturities due to the long-term nature of the liabilities they must fund. A commercial bank that has liabilities of a relatively short maturity may prefer to invest in shorter-term debt securities. Another argument for the market segmentation theory is that there are legal or institutional policy restrictions that prevent investors from purchasing securities with maturities outside a particular maturity range.

A somewhat weaker version of the market segmentation theory is the preferred habitat theory. Under this theory, yields also depend on supply and demand for various maturity ranges, but investors can be induced to move from their preferred maturity ranges when yields are sufficiently higher in other (non-preferred) maturity ranges.

The pure expectations theory by itself has no implications for the shape of the yield curve. The various expectations and the shapes that are consistent with them are:

1. Short-term rates expected to rise in the future -> upward sloping yield curve
2. Short-term rates are expected fall in the future -> downward sloping yield curve
3. Short-term rates expected to rise then fall -> humped yield curve
4. Short-term rates expected to remain constant -> flat yield curve

The shape of the yield curve, under the pure expectations theory, provides us with information about investor expectations about future short-term rates.

Under the liquidity preference theory, the yield curve may take on any of the shapes we have identified. If rates are expected to fall a great deal in the future, even adding a liquidity premium to the resulting negatively sloped yield curve can result in a downward sloping yield curve. A humped yield curve could still be humped even with a liquidity premium added to all the yields. Also note that , under the liquidity preference theory, an upward sloping yield curve can be consistent with expectations of declining short term rates in the future.

The market segmentation theory of the term structure is consistent with any yield curve shape. Under this theory, it is supply and demand for debt securities at each maturity range that determines the yield for that maturity range. There is no specific linkage among the yields at different maturities, although, under the preferred habitat theory, higher rates at an adjacent maturity range can induce investors to purchase bonds with maturities outside their preferred range of maturities.

Conrad showed us to this site where you can learn more about bonds. You can click on the link here.

Rates & Bonds

For those who wish to know the different rates in the market now, for e.g. the 3-Month LIBOR rate, US Treasuries bill rate etc., you can find good information by clicking this link here: http://www.bloomberg.com/markets/rates