The most widely used of all U.S. Government securities, and a primary instrument of Federal Reserve policy, Treasury Bills, like Treasury Bonds, are issued to the public at a guaranteed rate of interest to pay off maturing debt and to raise more cash for operating the federal government, which backs them with its full faith and credit.
There is no investment in the world where the return of principal is more assured. Because of this, T-bills generally produce lower returns than corporate issues of comparable maturities, or competing, albeit chancier, investment options like stocks - with which there is no assurance that one's principal will be returned, and arguably little current return on that principal while waiting. But given the fact that equities can often produce substantial gains, investors in Treasury bills pay for this safety net, since the flip side of not being able to lose a lot of money is the inability to make as much, either.
Similar to zero coupon bonds, T-bills return no interest to the investor until maturity. But unlike bonds in general, T-bills mature very quickly. The most commonly issued is the 3-month bill. But six-month and 12-month T-bills are issued as well. All are sold at a discount from par value in minimum denominations of $1,000 to a ceiling of $1 million. The difference between the T-bill's discounted purchase price and its par value is your return.
For example, if you buy a 1-year T-bill sold at a discount of 5 percent, your purchase price would be 95 percent of the T-bill's $1,000 value, or $950. When the bill matures, you get back your $950 plus $50 interest earned on your investment in the course of that year.
Two mathematical formulas can be employed to calculated yields on 3-month, 6-month, and 1-year T-bills. Both use the investor's return (difference between purchase price and par value) in the calculation. But the first, called the Discount Yield method, takes into account the bill's return as a percent of its par value, not its purchase price, to determine annual yield. The second, known as the Investment Yield method, relates return to purchase price to determine current yield, so that investors can compare the security's attractiveness to other short-term investments available on the open market and access "opportunity risk" - what the same amount of money might earn elsewhere.
Both methods are fairly straightforward and can be easily figured on your own. To see how they work, let's use an example of a T-bill sold at a discount price of $9,800 and maturing at $10,000 in either 3-month, 6-month, or 1 year. In the Discount Yield method, the approximate number of days in the year used for calculating is 360; it's 365 in the Investment Yield method.
