What happens to Treasury bill yields when interest rates go up? Do they react the same way as bonds?

--Mary Anile-Liberatore


There are two important differences between how interest-rate moves -- by which I mean increases or decreases in the fed funds rate by the Fed -- affect Treasury bill yields, and how they affect other Treasury yields.

For one, bill yields are more closely influenced by the fed funds rate. You can rely on them to move up and down with the fed funds rate (or when the Fed is expected to change the rate in the near term). By contrast, the reaction of Treasury note and bond yields to changes in the fed funds rate is sometimes more complicated. This is because bills are short-term instruments, while notes and bonds are intermediate- or long-term instruments.

Second, bill yields are much more sensitive to the forces of supply and demand than note and bond yields. Bill yields can swing wildly around the fed funds rate, depending on whether the Treasury Department is issuing more or fewer bills than investors want.

"The whole Treasury market is very sensitive to supply and demand concerns, but none more so than the bill sector," says Ken Logan, managing analyst at IFR/Thomson Financial.

Treasury bills are the shortest-term Treasury issues -- they come in three-month and six-month varieties. The fed funds rate, on the other hand, is the rate at which banks lend one another excess reserves -- reserves they don't need to satisfy capital requirements -- overnight.

Treasury bills are more predictably influenced by the fed funds rate than notes and bonds because Treasury bills and the fed funds rate are competing investments in the money market. The money market is the market for high-quality, short-term debt instruments. Just as individuals put uninvested cash into money market mutual funds, where they can earn interest without putting principal at risk, institutional investors for the same purpose invest directly in the money markets by buying instruments like fed funds and Treasury bills. As investments, fed funds and Treasury bills generally offer comparable yields.

Note and bond yields are less closely tied to the fed funds rate because their longer maturities (from two to 30 years) mean more can happen during their lifetime. That gives them the potential to undergo big price changes. In general, the longer the maturity of a debt security, the greater the potential price changes.

The potential for big price changes makes investors willing, under certain circumstances, to accept lower yields on notes and bonds than on bills.

This anticipatory nature of intermediate- and long-term Treasuries also means that their yields don't always move in the same direction as the fed funds rate. A hike in the fed funds rate -- particularly if it's the latest is a series of hikes -- can send note and bond yields lower if investors think the hike will slow economic growth too much and eventually lead the Fed to lower the rate. Conversely, a cut in the fed funds rate, particularly if it's the latest in a series, can cause note and bond yields to rise if investors think it will overstimulate the economy, eventually leading the Fed to embark on a series of rate hikes.

But if Treasury bill yields are more predictable with respect to the fed funds rate than note and bond yields, they also are more vulnerable to shifts based on supply and demand.

There are two reasons for this. First, bill issuance is less predictable than note and bond issuance. The Treasury issues notes and bonds on a fixed schedule (two-year notes monthly, other notes and bonds quarterly), and even though there is always some mystery about the size of the auctions, surprises are few and far between. Bills also are issued on a regular, weekly schedule, but size adjustments are much more common. Also, the Treasury issues special "cash management bills" in addition to its regular issues when it can't make size adjustments large enough to meet its immediate financing needs; this occurs on a regular basis.

Second, demand for Treasury bills is much more rigid than demand for notes and bonds. Treasury bills are the quintessential risk-free asset. Like all Treasury securities, they are free of credit risk. And as short-term instruments, they also are free of interest rate risk. Investors who want a totally risk-free asset -- or institutional investors that have internal requirements regarding totally risk-free assets -- have no choice but to buy Treasury bills.

"Treasury bill yields in general tend to be artificially low because a few accounts will sacrifice a good deal of yield for a legally risk-free instrument," Wrightsom & Associates chief economist Lou Crandall explains.

In other words, the mechanism that keeps Treasury note and bond yields from dropping too low -- people will resist buying them -- isn't present to the same degree in the bill market. Accordingly, a shortage of bills can cause their yields to drop sharply, regardless of where the fed funds rate stands.