Wednesday, September 29, 2010

A short lesson on how US Treasury's work---It is very "interest"ing...

     The US government (all governments for that matter) finance spending through (1) tax receipts and/or (2) issuing promissory notes, called bonds, securities, Treasury notes, Treasury Bills ("T-Bills"), or some combination thereof.  All these names have significance but for this blog entry I will refer to Treasury Bills (T-Bills) or more simply as "Treasury's". 
     Treasury's are "marketable securities" and are very short-term in length (4weeks, 90 days, 180 days, 365 days).  They are considered debt instruments and are traded in secondary markets world-wide.  As such, they are subjected to the laws of supply and demand and each Treasury has a price attached to it. How is that price determined? Glad you asked. 
     Let's assume the government wants to raise some money from the market-place instead of printing it.  To do this they issue a Treasury Bill (or Note) with a face value of $100.  No one is going to pay $100 for a $100 dollar Treasury so the government has to sell it for something less than $100.  Assume the marketplace has determined the current market price for a $100 face value US Treasury is $90.  See the graph below:

     If I purchase this Treasury for $90 and can redeem it sometime in the future for $100 then I have made $10 on the transaction.  If you convert this gain into a rate of return, or interest rate, we have a percentage gain of 11.11%! ($10 gain divided by my investment of $90 times 100 equals 11.11%).  So my Treasury is priced at $90 and has a potential gain of 11.11%.  Good enough...But we are not done.
     Because Treasury's are traded in secondary markets world-wide, the price of the Treasury is subject to change. Assume there is economic uncertainty in other developed countries and their markets are in turmoil.  Investors look not only for high rates of return, but stability and some level security for there money. THE safest investment is US government debt, i.e. Treasury's and is considered a safe-haven to park financial capital.  The turmoil in foreign markets creates an increase in demand for Treasury's.  See graph below to see the effect on the market for US Treasury's:
     Notice the Price of Treasury's has increased to $95 (I made the new price up) relative to the previous price of $90.  NOW the $100 face-value Treasury is priced at $95.  So now the owner of this Treasury can redeem it for  $100.  His profit would be $5.00.  Converting this into an interest rate, or rate of return, we can see the effective interest rate is now 5.26% ($5.00 divided by $95 times 100 = 5.26%). This is considerably less than the previous effective interest rate of 11.11%. 
     IMPORTANT observation:  As the price of the Treasury INCREASED the Interest Rate earned from it DECREASED!  There is an inverse relationship between the price of a Treasury and the Interest Rate it earns.  Repeat that to yourself---it is important. 
    Currently there is significant demand for US Treasury's because they are seen as a safe-haven investment, and it is driving the price of them up and decreasing the yields (rate of return).  The Federal Government can borrow money at a VERY low interest rate (click HERE for latest rates).
   IF investor confidence improves and stocks and/or other investments become more attractive then the demand for Treasury's will decrease, the price will decrease and the interest rate will increase.  This is a negative for the Federal Government because they will have to offer higher interest rates to attract money to finance deficit spending. This will increase the interest payment outlays in the federal budget.
    Hopefully you learned a little bit of how Federal debt instruments work.  If is understood by the few, but it affects the many...
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