In addition to issuing long term bonds, governments issue short-term Treasury bills (T bills) of up to one year maturity. These do not carry a coupon, but are sold on a discount basis.

For example, the US Treasury, UK government and the French government are all active and regular issuers of bills. These represent the highest quality money market instruments available from a credit standpoint, and are used by researchers to measure short term risk-free rates.

In the UK, T bills are issued by the Bank of England on behalf of the government, normally on a weekly basis and normally by tender. Treasury bills can be issued for any term up to one year but the tendency has been to issue for 3 or 6 month periods. At the tender the prospective purchaser has to indicate the price he is prepared to pay. This price is a function of the interest rate expected.

Issue Price: Discount yield and True Yield

For example, if a bid of GBP 975,342.47 is tendered for a 90-day UK Treasury bill of one million pounds, it is because the bidder wishes to receive 7% discount. The amount of the discount bid is:

GBP 1,000,000 X 7% X 90/365   = GBP 17,260.27

The tendered price is therefore:         GBP 982,739.73

The add-on yield equivalent is:

GBP 17,260.27/GBP 982,739.73 X 365/90 = 7.12%

Secondary Market Trading

In the secondary markets, Treasury bills trade on a straight discount basis. The rates quoted on brokers screens are discount rates. They are therefore not comparable to commercial paper rates, which are add-on yields, unless converted.

The issuance of T-bills affects the money supply by temporarily soaking up liquidity. Buyers pay cash in exchange for promises to pay, and so cash is drained from the monetary system. Conversely, bills can be bought back to inject funds into the system. Selling unexpectedly large amounts of T bills tends to nudge interest rates upwards, since the average rate of accepted bids rises. Selling fewer bills than expected tends to nudge interest rates downwards. The central banks also stand ready to buy up T bills from traders or banks in need of temporary liquidity (such as when there is a ‘run on the bank’).

All the major bill markets have primary traders who are given special information and dealing privileges in return for obligations to buy certain percentages of the new issues. There is always a good liquid market in Treasury bills.

Traders aim to buy at a high rate of discount and sell at a lower rate of discount. A trder who buys USD 1,000,000 of 70 day US T bills at 5.625% on the same day has traded at the following prices:

Purchase – USD 988,819.44

Sale        + USD 989,062.50

Profit      + USD 243.06

Rider:

1. You buy 90-day treasuries with a yield of 4.24%.The face amount is USD 10 million. What would you pay for them?

2. You sell on the treasuries 21 days later at 4.15%.What would you receive for them?

Solution:

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