How Treasury Bill Interest Rates Are Determined
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How Treasury Bill Interest Rates Are Determined

4 Min.

Investors' willingness to take risks is largely influenced by the prices of T-bills. In fact, the prices and yields of T-bills and other Treasuries are used to determine the fundamentals of almost all other investment classes in the market. T-bill prices are established through interval auctions. There are two types of bidders for T-bills: competitive and non-competitive bidders. Although they offer low returns, Treasury bills are considered one of the safest investments in the world.

Basics

U.S. Treasury bills, commonly called T-bills, are sold at auctions with a discount from their face value. In contrast to other U.S. Treasury securities like Treasury notes (T-notes) and Treasury bonds (T-bonds), T-bills lack the feature of providing periodic interest every six months. The interest rate for Treasury bills is established by considering both the overall discounted value and the duration until maturity.

T-Bill Auctions: Maturity Intervals and Bidder Types

Treasury bill auctions occur regularly, with separate schedules for various maturities. The 13-week and 26-week T-bills are auctioned every Monday during active financial market hours, while 52-week T-bills are auctioned every fourth Tuesday. Announcements on new T-bills issuance and face values are made each Thursday, providing potential buyers with the necessary information for planning their purchases.

Two distinct types of bidders participate in Treasury bill auctions: competitive and noncompetitive. Competitive bidders play a pivotal role in determining the discount rate. Each competitive bidder declares their proposed price, and the Treasury accepts bids in descending order of price until the total face value for a specific maturity is exhausted. Noncompetitive bidders commit to purchasing at the average price of all accepted competitive bids.

Exploring T-Bill Face Value Redemption and Interest Rates

Investors holding T-bills until maturity are assured of receiving the full face value for their investments. The interest rate is determined by the difference between the discounted purchase price and the face value redemption amount. 

Consider a scenario where an investor acquires a 52-week T-bill with a face value of $1,000, paying an upfront cost of $975. The discount spread, in this case, is $25. Upon receiving the $1,000 at the end of the 52-week period, the earned interest rate is 2.56% (25 / 975 = 0.0256).

It's crucial to note that the interest rate on a T-bill doesn't necessarily match its discount yield, which represents the annualized rate of return for the investor. Furthermore, discount yields fluctuate throughout the security's lifespan. The term "discount rate" is sometimes interchangeably used with discount yield but should not be confused with the actual interest rate.

Market Dynamics: Influences on Treasury Bill Pricing

Various external factors influence the discount price of T-bills, with notable impact from shifts in the federal funds rate. T-bills, in comparison to other government securities, are exceptionally responsive to changes in the federal funds rate due to their direct competition within the market for low-risk, short-term debt instruments. Institutional investors closely monitor the federal funds rate range and T-bill yields in their investment risk analysis.

In the realm of debt securities, T-bills stand out for their unparalleled liquidity and minimal principal risk. The pricing of Treasury bills can significantly affect the risk premium imposed by investors across the entire market. Functioning like bonds, T-bills have an inverse relationship between prices and yields. When prices rise, yields drop, and vice versa. They serve as a quasi-risk-free return in the market, prompting other investments to offer a risk premium in the form of higher returns to attract capital away from Treasuries.

Economic Dynamics and T-Bill Pricing Influences

T-Bill prices are subject to various influences beyond the federal funds rate. In periods of robust economic growth, investor risk aversion decreases, resulting in diminished demand for bills. As T-bill yields climb, a ripple effect ensues: bond rates and equity's required rate of return rise, along with an increase in mortgage rates, while the appeal for other "safe" commodities wanes.

Conversely, during economic downturns, investors shift from riskier assets, causing T-bill prices to rise and yields to fall. The lower T-bill interest rates prompt investors to seek riskier returns elsewhere in the market, especially when inflation rates surpass T-bill returns, yielding a negative real rate of return.

Inflation further impacts T-bill rates. Investors hesitate to acquire Treasuries when yields fail to keep pace with inflation, translating into a net loss in real purchasing power. High inflation correlates with lower Treasury prices and higher yields, whereas low inflation tends to elevate prices. Additionally, inflation's influence on T-bill rates is shaped by the Federal Reserve's management of the money supply.

Conclusion

The U.S. Treasury calculates Treasury Bill interest rates based on their term and overall discounted value, commonly referred to as the coupon equivalent.

Treasury Bill
Interest Rate
Competitive Bidder
Non-Competitive Bidder
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