treasury bills and money market mechanics

In short

A friend of mine once asked why his savings account paid so little while the news said short term rates were high. If you hold cash you will need within a year, this guide is for you. A Treasury bill is a loan you make to the U.S. government that lasts one year or less. You buy it for less than its face value, and you get the full face value back at maturity. The gap between those two prices is your interest. A money market fund is a different thing, because it pools many investors' cash and holds short term debt for them. Both are worth understanding before you decide anything on your own.

The whole of it

What it is

I once watched my neighbor fold a crisp bill into his shirt pocket and say he was "lending Uncle Sam a few weeks of his money." That is about as plain as it gets. A Treasury bill, or T bill, is a short term loan to the federal government. The Department of the Treasury sells bills in several short terms, from a few weeks up to one year. The TreasuryDirect website lists the terms on offer, and the Bureau of the Fiscal Service runs that site.

A bill pays no coupon. That means it sends no interest checks along the way. Instead, the buyer pays a price below face value and collects the full face value at the end. The difference is the earnings.

A money market fund works another way. If you have ever put cash into a brokerage account, you may have seen one. The fund collects money from many investors and buys short term debt, such as Treasury bills, repurchase agreements, and high quality commercial paper. The Securities and Exchange Commission regulates these funds under Rule 2a-7, and its Investor.gov site explains how they work. Some money market funds hold only government debt. Others hold a wider mix.

A money market fund is not a bank account. The FDIC insures deposits at banks, and it does not insure shares of a money market fund. Treasury bills carry the backing of the U.S. government. A fund is only as sound as what it holds. That is worth knowing.

How it works

If you are holding a bill, the mechanics are simple once you see them. The Treasury sells new bills at auction. Buyers bid, and the price settles where the supply meets the demand. Anyone can bid without competing on price by placing a noncompetitive bid, and that bid gets filled at the average result of the auction. TreasuryDirect lets individuals do this directly.

Bills are quoted in two ways, and this trips people up. One is the discount rate, which is figured against face value. The other is the investment rate, sometimes called the coupon equivalent yield. It is figured against what the buyer actually paid. The investment rate is the better match for comparing a bill to a savings account, because it measures the gain on the money you really put in.

Here is the arithmetic for the investment rate. Take the gain, divide by the price paid, and then scale it to a full year of 365 days. For a bill bought at $9,900 that returns $10,000 after 91 days, the gain is $100. The $100 gain divided by $9,900 is about 0.0101. Multiply by 365 and divide by 91, and you get about 4.05 percent. That annual figure is the investment rate.

A fund works differently. It holds many short loans that come due at different times. As each one matures, the fund buys new ones. So the fund's yield moves as rates move. A fund shows a seven day yield, which the SEC defines as the income over the last seven days, scaled up to a year. The yield changes. What about the share price? Under Rule 2a-7, the SEC explains on Investor.gov that these funds seek to keep a stable net asset value, and the usual target is $1.00 a share. Read the fund's own prospectus to see what it says about its price.

One more piece matters. Interest from Treasury bills is taxed by the federal government. It is exempt from state and local income tax, according to the Treasury. A fund that holds Treasury bills may pass some of that benefit along, but the rules depend on the fund and the state. Check your own state's rules. A tax preparer can sort that out.

The numbers, and where to find yours

You have probably wondered where to look so you are not guessing. The recent auction results are published on TreasuryDirect, and they show the rate for each bill length. The Treasury also publishes daily yield curve rates on its website, and those rates show what short term borrowing costs on a given day.

For a fund, find the fund's fact sheet or prospectus. The seven day yield and the expense ratio are listed there. The expense ratio is the yearly fee, shown as a percent of what you hold. A higher fee eats into your yield. The fund also lists its holdings, so you can see whether it owns only government debt or something broader.

For the minimum purchase, TreasuryDirect sets a floor. The minimum amount is the current figure, which the official source publishes each year. The increments above that are set the same way. Do not rely on a figure from memory. The official page is the one to trust, because it changes.

For tax, the rate you pay on the interest depends on your bracket. The IRS publishes the brackets each year, and the current ones are on IRS.gov. The state exemption is real. Whether it saves you much depends on where you live.

A worked example

A neighbor of mine, Margaret Ellison, sold a small piece of land and held $20,000 she planned to spend on a roof in about six months. She did not want to risk a loss. She also did not like how little her bank paid.

She looked at a 26 week bill. Say it was offered at a price that works out to $19,600 per $20,000 of face value. She would pay $19,600 and receive $20,000 at maturity. Her gain is $20,000 minus $19,600, which is $400.

Now the rate. Her gain of $400 divided by the $19,600 she paid is about 0.0204. A 26 week bill lasts 182 days. Scaling to a year, 0.0204 times 365 divided by 182 is about 0.0409, or roughly 4.09 percent. That is the investment rate on her purchase.

Compare that with her bank. Suppose the bank paid 0.50 percent. On $19,600 for 182 days, that is $19,600 times 0.005 times 182 divided by 365, which is about $48.86. The bill gave her $400 against the bank's roughly $49. Her gain from the bill was about $351 more over the six months.

She then asked about taxes. Say her federal rate on that interest is 22 percent. The tax on $400 is $400 times 0.22, which is $88. So her after tax gain is $400 minus $88, or $312. The bill's interest is exempt from state income tax, so there is no state bill on it. Her roof money arrived on schedule, and she kept her sleep.

Notice what she did not do. She did not need to guess about rates. She read the auction result and did the sums.

Where it goes wrong

I once watched a good fellow lose his patience over a small thing, and it cost him. The common slip with bills is mixing up the discount rate with the investment rate. They are not the same number. A discount rate of 4.00 percent is lower than the investment rate on the same bill. Compare like with like.

Another slip is forgetting the timing. A bill locks up your money until it matures, unless you sell it early on the market. If you sell early, the price may be lower than you paid. Match the bill length to the date you will need the cash.

A third slip is treating a money market fund as if it were insured. It is not. The fund's shares can lose value, and the Investor.gov pages on money market funds say so plainly, so read the risk language there and in your fund's prospectus. The SEC also has rules on liquidity and fees for these funds. Read what your fund holds.

Fees also bite. A fund with a high expense ratio can leave you with less than a plain bill would. Run the numbers on your own balance.

Last, taxes catch people off guard. Bill interest is not tax free at the federal level. Plan for it. Interest still counts as income.

Questions to answer before you leave this page

When will you need this money, and does a bill that matures on that date fit your plan? Do you know whether you are reading a discount rate or an investment rate? Have you looked at the latest auction result on TreasuryDirect, and have you checked the current minimum purchase there? If you are weighing a fund, have you read its seven day yield, its expense ratio, and its list of holdings? Do you know that a fund is not insured the way a bank deposit is? Have you worked out your after tax gain using your own federal bracket and your own state's rules? And could a tax preparer or the official pages answer anything you still feel unsure about?