19

Why would anyone buy a 1 yr T-Bill with a return of 1.25% when you get double that on a 30-year T-Bond? Where is the risk and/or liquidity premium coming from?

There's a highly liquid, secondary market where you can exit a position at any time, right? Especially during a crisis...any crisis, from a 9/11 to an '08 bubble to a pandemic, yields plummet when everyone rushes to the safety of treasuries.

And if there's uber liquidity for bills, notes, and bonds in times of stress, then how can there be a risk premium? They're zero default, which just leaves inflation...which is more volatile for a bill than a bond, right?

What am I missing here?

4 Answers 4

32

There are some good answers already but I think it would help to walk through a concrete scenario under your implied hypothesis.

"Why buy a 1-year Treasury Bill at 1.25%, when I can buy a 30-year Treasury Bond at 2.5%, and then in 1 year simply sell the 30-year T-bill?"

The short version of the below is, firstly to assume that the auction of US Treasury Securities, one of the most massive and efficient markets in the world, is fairly priced. Any fixed income security will fluctuate in value based on competitive rates available in the market, and a 30 year security needs a loooooong time to wait maturity, and therefore a long period of time for volatility to impact the price.

Selling US Treasury securities into the market is quick and easy, but only at the price deemed fair by the market at that time, which will change based on market sentiment, whereas only waiting for maturity will deliver you a precisely defined value at the end of the term.

Before we go further, remember that a 1 year T-bill offers you the right to receive back from the government the face value of $1,000 in 12 months, with a discounted purchase price today based on how much the market is willing to buy that t-bill for [at 1.25% effective market rate, you would need to pay about $987 today, to buy a t-bill that gives you back $1k in a year, if you plug those numbers into a financial calculator].

First, assume you bought a 1-year T-bill today for $987. How much could you sell it for, if you needed to liquidate tomorrow? What does your gut say? It seems reasonable to assume that in an efficient market, selling something as liquid as a T-bill 1 day after purchase would give you back basically your original purchase price. This core assumption holds roughly true, with 2 caveats:

  • A 1-year t-bill essentially moves towards 'face value' [the $1,000 t-bill amount] every day, as it gets closer to maturity. So, you should expect to receive back only slightly more than your original $987 purchase price, representing basically 1/365 days of interest accrued.
  • In between the time you purchase and the time you sell, market conditions could change, making investors change their perception of the value of your t-bill. If you bought a $1,000 t-bill yesterday for $987 [implying an effective interest rate of 1.25%], and the federal reserve increased its lending rate today by 25 basis points, then the market would demand more compensation for any new t-bills. If a new 1-year t-bill would cost someone $985 [implying a rate of 1.5% annually], then why would they pay $987 for the t-bill you bought yesterday? They wouldn't - they would demand that you drop your price to match their expectations, meaning if you sold tomorrow after a 0.25% drop in market interest rate, you would lose $2 in just a single day.
  • Regardless of what you could sell it for tomorrow, if you wait another 364 days, you will receive $1,000 in maturity value.

So, t-bills are incredibly liquid, because they are in high demand, and incredibly secure, because they are guaranteed by the US Government, but an efficient market price for those t-bills will still fluctuate based on revised market conditions.

Now expand that logic to look at a 30 year Treasury Bond instead.

A Treasury bond pays out its stated interest rate [which is different than the effective interest rate considering all factors!] on the face value of the bond, every 6 months. The price of that bond will be discounted, just like the price of a 12 month Treasury Bill, based on what the market is willing to pay for it. If the bond has a $1,000 face value [amount returned in 30 years] and costs you $950, and pays you interest annually of 2.5%, then the implied interest rate is about 2.75%, if you plug that into a financial calculator.

What happens to the value of your Treasury Bond in 12 months, when you want to sell?

  • If there is no change to market conditions between now and next year, then a Treasury bond maturing in 29 years would have a fair value just slightly higher than your original price of $950. Just like with the t-bill, because you are 1 year closer to the 30-year maturity, you would expect that you should get something like 1/30th of the accrued differential between $950 and $1,000, because in 29 years a matured t-bill would return you its face value.

So again, with no change to market conditions, you could expect to sell back your treasury bond to someone else in the market for something like $950.5, having already received $25 in interest payments during the year. The value of receiving $975.5 from interest + sale proceeds after 1 year, at a cost of $950, implies an effective interest rate of about 2.65%. So not the full 2.75% we originally calculated as the implied interest rate, because you haven't earned the full-term value of the price differential between $1,000 maturity and the original price of $950.

This means that in a circumstance where there is no change to market conditions, at the above initial short and long-term interest rates, buying a 30-year treasury bond would offer a higher return than buying a short-term t-bill. So why would anyone by the short-term t-bill then?

Let's finally look at what happens if the market conditions change.

  • Assume suddenly the market decides that a fair rate of interest for a 30-year t-bond isn't 2.75%, it's actually 3% [as determined by the trillions of dollars of fair market auctions of people buying that debt from the US government, probably based on something like an increasingly positive outlook on the global economic situation for the next decade which would imply a future increase to central bank comparative interest rates].

This means that someone buying a new bond wouldn't pay $950 for it anymore - they would pay something like only $896! When you try to sell your old t-bond in the market, you won't even get back your original purchase price - you would get back something like $898 [again, accruing a bit of additional value for the fact that you are 1 year closer to receiving the face value on maturity, compared with a new 30-year bond].

$898 sale price in 1 year + $25 in interest payments during the year, means that you would get back $923 cash inflows for something that cost you $950 in the first place - you would have lost $27! Compare that with a 1-year t-bill which would have cost you $987 and matured at $1,000, which would have been a cash profit for the year of $13 [the 1.25% we originally mentioned].

So in summary:

  1. Yes, the face value of a long-term t-bond and the intervening semi-annual interest payments are secured by the government; and
  2. Yes, the market for treasury securities is so massive that you can assume high liquidity to sell your shares quickly when needed; BUT!
  3. The value you receive for a premature sale of any fixed income security will fluctuate based on the difference between your original implied interest rate at the time of purchase, compared with the new interest rate demanded by the market based on economic conditions at the time you have to sell; AND!
  4. Long-term securities are more significantly impacted by fluctuations in market interest rate, because that implied interest rate covers a much longer period of time. Per the above example, a 30-year bond loses $27 in value over just 1 year with a 0.25% increase to demanded market interest rate over a year, while a 1-year t-bill loses just $2 in value if there is a 0.25% increase to demanded market interest rate the day after you buy it. This is intuitive: If your t-bill now earns 0.25% less than a new t-bill with a better interest rate, you lose 0.25% for a single year (a couple of bucks). If your t-bond earns 0.25% than a new t-bond with a better interest rate, you lose 0.25% for 30 years!
1
  • 1
    Thank you for the worked example, that is what I was missing.
    – EricP
    Mar 16, 2022 at 15:49
36

The basic detail you're missing is that you can't redeem the bond for it's face/par value until maturity. If you buy the 30 year bond at 2.5% now, and in one year's time the rate for a new 29 year bond is 3.5%, then that's 29 years of an extra 1% interest that you'll miss out on.

Yes, you can sell the bond into a liquid market, but only for what someone is willing to pay - which in the scenario I suggest, will be less than the face value.

7

You cannot count on a crisis (specifically a deflationary crisis) happening just when you want to liquidate. If you need to sell a long-term bond (before maturity) during unexpectedly strong economic growth or high inflation, you will take a hit as rising interest rates send its price down. For example, the TLT ETF (representative of long-term Treasury bonds) is currently down about 11% year-to-date.

2
  • As for risk, I was just pointing out that it's the only always liquid market. Anything else, equities, commercial paper, even gold are liquid until they aren't. --- Also, for bond prices, I guess I need to do some worked examples to understand it. Like how a 40 bps bump on 30 yr equates to a 11% loss on TLT whereas a 70 bps bump in the 5 yr only equates to a 2% loss for SHY.
    – EricP
    Mar 16, 2022 at 15:19
  • 1
    @EricP SHY holds maturities of 1-3 years, not 5 years. But yes, prices of long-term bonds are more sensitive to interest rates simply because there is more time for the interest to accumulate.
    – nanoman
    Mar 16, 2022 at 15:27
2

Two other issues come to mind:

  • If the liquidity of the market and the issuer were all that mattered, different bonds/bills would just be like different denominations of currency. But different durations have buy-and-hold investors, as well. Insurance companies can match duration to their liabilities. Corporations can hold bills (but not bonds) as cash equivalents on their balance sheet.

  • Inflation does not necessarily affect bills more than it affects bonds. E.g. if a new baby boom started, short-term inflation would stay low while long-term inflation would spike in anticipation of the baby boom's teenage years.

1
  • A nicely stated "because term structure of interest rates" answer.
    – user68318
    Jul 28, 2023 at 16:44

You must log in to answer this question.

Not the answer you're looking for? Browse other questions tagged .