Treasury Yield - Explained
What is a Treasury Yield?
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Table of ContentsWhat is a Treasury Yield?How Does a Treasury Yield Work?Shifts in Treasury YieldsYields on T-BillsYield on T-Notes and T-Bonds
What is a Treasury Yield?
Treasury yield refers to the percentage return on investment (ROI) on the U.S. government debt instruments. For simplicity, Treasury Yield is the interest that the Treasury department pays you for allowing the government to borrow money from you for a fixed duration. Investors have different feelings about an economy, and their sentiments are generally expressed by the movement of Treasury Yields. It is a common misconception that yield curves are focused solely on how government borrows and pays back bonds and notes and how much investors gain in the form of interests. It is important to note that yield curves have an effect on the economy, and the higher the yields on a decade, two-decade and three-decade Treasuries, the better an economy is said to be.
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How Does a Treasury Yield Work?
The United States government generally offers debt instruments through the Treasury Department to finance projects and other national needs. These instruments are made available in forms of Treasury Bills (T-Bills) which mature within a year, Notes (T-Notes) which mature within ten years, and Bonds (T-Bonds) which can have a maturity duration of 20 up to 30 years.
Shifts in Treasury Yields
Treasuries are said to be low to no risk investments as they are backed by the U.S. government. These deb instruments are loaned to the government by investors, who in turn receive coupons semi-annually and a total interest at the end of maturity. These coupons represent the cost of lending the government money, and they are given to investors and shareholders as compensation for doing so. Treasuries yields are calculated by demand and supply, just like every financial, economic concept. Each treasury is issued with a face value (the nominal value or dollar value), and a fixed interest rate which is purchased in the auction, or by the top bidder in the case of a secondary market. In a situation where demand is higher than expected, treasuries will cost higher than their initial amount (known as a premium) and will sell at a price higher than their face value. This will reduce the returns earned by the investor, as the government only pays an amount equal to the face value upon maturity. An example will be a lender who buys 20 units of bonds at $20,200. The government will only pay the face value of $20,000. Thus, the lender will be said to have lost $200 in monetary terms. On the other hand, if deemed is lower than expected, the Treasury Yield will increase to compensate for it. In a case like this, investors will be willing to pay a price below the face value. This increases the yield as the government will always pay at face value even if an investor purchases 20 units at $19,000. The government, however, will be more willing to increase its interest rates to attract more buyers ad drive price above or equivalent to the face value. Treasury yields will also increase if the government reserve employs monetary policies (increases its federal fund rate target), or if market sentiments run wild. Each security has different yield, and with other factors kept constant, securities which take a longer time to mature have higher yields than those that mature quickly like the T-Bills. The U.S government is transparent with the yield on each debt instrument given their duration, and it is published daily on its website for every investor to see. On November 29, 2017, the yield on a Treasury Bill of 3-month was 1.28%, a 10-year Treasury note was 2.39%, and that of a 30-year bond was 2.82%.
Yields on T-Bills
The Treasury bill is a zero-coupon debt instrument (doesn't pay interest nor coupon), which is usually auctioned out at a price below face value and redeemed at face value. In other words, yields or interest from T-bills are gotten from the difference between the actual value and the discounted value for which it was purchased. T-bills are given out at weekly auctions, and they are done frequently due to the short duration of their maturity. At maturity, T-bills are paid back to investors at face value and not at the price at which they were purchased. An example would be twenty bills at $20,000, which was purchased by an investor at $17,000. When such a bill matures, the investor will take home the actual face value of the bills ($20,000) rather than the discounted value ($17,000). Thus, the interest is said to be $3000, but not noted as such. In measuring the percentage value of yields, investors can choose to make use of the interest or the discount yield model. The former makes use of a normal calendar year (365 days or 366 in the case of a leap year), while the latter makes use of bank calendar year (360 days). The discount method is generally used in calculating returns as T-bills are both below their actual price.
Yield on T-Notes and T-Bonds
Yields on T-notes and T-bonds are the semi-annually issued coupon payments and their nominal value at maturity. Notes and bonds are usually purchased at their actual value, at a discount as seen in T-bills, or at a value higher than their face value (premium). These modes of auctions are dependent on the demand and supply of such treasury securities both at government auctions ad in the secondary markets. Treasury securities, when bought at discount rates will have a yield that is higher than their coupon rates. When bought at a premium, their coupon rates will be higher than the yield. Also, if demand and supply are at equilibrium, treasury notes and bills will have a yield equivalent to their coupon rate, since theyll be bought at their actual value (i.e., $1000 per denomination). Mathematically, treasury yields on notes and bills are calculated using: Treasury Yield = [C + ((FV - PP)/T)] / [(FV + PP)/2]. Here, C = Coupon rate in % FV= Face value or actual price PP = Purchase price (at a discount, nominal value, or a premium) T = Length of maturity So for a 5-year bond or note with 5% coupon rate and $10,000 face value purchased at $8000, the yield will be 4.445% if held till maturity. Treasury securities have very low returns due to their low risks, and this can encourage investors to engage in higher-risk investments like stocks and shares due to the possibility of higher returns.