Treasury Bills

A safe haven

Treasury bills are short term debt instruments issued by governments to meet their financing requirements or drain liquidity from the financial system. The credit risk is that of the sovereign issuer. The maturities are short dated typically 3, 6, 9 or 12 months. And the market is liquid, (T-bills can easily be sold for cash with minimum transaction costs). For these reasons in times of market uncertainty investors increase their holdings of treasury bills.

The cost

This may seem perfect from an investment perspective but such a low risk instrument has one major drawback. The investment return on T-bills is normally significantly beneath the return on other money market investments.

For fund managers this can be an opportunity cost, they just earn a low return from investing. For investors that finance their investments there is a real cost. This is the case for banks where wholesale and retail funding costs exceed the return from investing in T-bills.

A Barometer

The difference in the yield (rate of return) between the London Interbank Offered Rate (Libor) and the yield on similarly dated T-bills in the same currency gives you a measure of the market’s perception of risk or stress in the banking system. This measure has been used by traders for many years and is sometimes (loosely) referred to as the TED spread. How does the TED spread work? It’s simple. Compare the 3 month Libor rate with the 3 month T-bill yield. What would you expect?

The Libor rate represents the interest rate where banks lend money to each other. The T-bill yield is the return on government debt. I think you will agree that you would normally expect the T-bill yield to be lower than Libor. This is indeed the case. (There is a risk premium associated with interbank lending). What happens to this premium in times of stress?

It widens. This is because in times of stress two things happen that effect the TED spread.

Investors increase their purchase of T-bills. When demand increases the price increases. Increased T-bill prices mean lower T-bill yields.
At the same time the cost of money to banks tends to increase as they find it harder to attract funds.

The net effect is an increase or widening in the TED spread. In times of calm investors become less risk averse and the spread contracts. The next time you need a measure of systemic risk have a look at the TED.

Comparisons

Comparing Libor rates and T-bill yields needs a little care. Libor is quoted on an actual 360 day count basis. Many T-bills yields are quoted on a discount basis-this is different.

Here is an example:

A 91 day $1,000,000 T-bill is discounted at 4.00%

The discount is $1,000,000 x 4.00% x 91 / 360 = $10,111.11

The purchase price is $1,000,000 - $10,111.11 = $989,888.88

The yield on an Actual 360 basis is:

$10,111.11 / $989,888.88 x 360 / 91 = 4.04%

This yield can now be compared with 3 month Libor.

Liquidity

Liquidity risk is at the heart of the financial system. Financial institutions must have sufficient liquid resources to meet their obligations as and when they fall due. This is not only prudent, it is a regulatory requirement.

One way to achieve this would be to match the maturity of all loans and deposits. This would reduce the risk of insufficient liquidity but such matching would be difficult.

Many customers like instant access to their money. Many borrowers want long term facilities. Banks perform a role of maturity transformation. They borrow short term and lend long term and make a profit from the liquidity premium. Banks have held a small proportion of their balance sheet as liquid assets. This is to protect themselves against a call for cash in the event that depositors require immediate access to their funds.

Events since 2007 have led regulators to reconsider exactly how much banks should hold in liquid assets and also what form it should take. T-bills have become an instrument of choice for core liquidity holdings. Effectively the cost of banking has increased with larger holdings of T-bills in banks balance becoming mandatory.

First Published by Barbican Consulting Limited 2009