Estimating Yields on Treasury Securities
Description
This article is from the Investing Articles: Bonds series.
Estimating Yields on Treasury Securities
Treasury bills (T-bills) are debt instruments with maturities of one year or less. They are backed by the full faith and credit of the U.S. government. Treasury bills are low-risk investments with a broad and liquid secondary market.
The interest earned on Treasury securities is exempt from state and local taxes. However, because T-bills are free of default risk, T bills generally have lower yields than corporate issues of comparable maturities. The reason for this is that T-bills are free of default risk.
T-Bill Yields
T-bills are purchased by investors at a weekly auction. The investor pays less than face value for the T-Bills and they are redeemed at maturity at face value. The difference between the purchase price and the face value of the T-bill is the investor's return.
The investor's return is used in mathematical formulas to determine the yield on T-bills. The discount yield method, takes into account the return as a percent of the face value of a T-bill. It does not use its purchase price. The discount method tends to understate the yield because the purchase price is almost always less than face value. The investment yield method, is also used to calculate the yield. Unlike the discount yield formula, the investment yield method relates the investor's return to the purchase price of the bill.
The discount yield, the investment yield, the high, low and average prices of the auctioned T-bills, are made public in an official Treasury report shortly after the auction.
The Treasury uses the discount and investment formulas for calculating yields on all T-bills, except the one-year bill. Yields reported by the Treasury are precise to several decimal places.
The Discount Yield Method
The following formula was supplied by the U.S. Treasury and is used to determine the discount yield for T-bills that have three- or six-month maturities:
Discount yield = [FV - PP/FV] * [360/M]
FV = face value
PP = purchase price
M = maturity of bill. For a three-month T-bill (13 weeks) use 91, and for a six-month T-bill (26 weeks) use 182
360 = the number of days used by banks to determine short-term interest rates (the investment yield method is based on a calendar year: 365 days or 366 in leap years).
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