Treasury Bills versus Treasury Notes and Changes in Interest Rates The daily mar

Question

Treasury Bills versus Treasury Notes and Changes in Interest Rates

The daily market transactions for treasury instruments are in the billions. The current average daily volume of “Treasuries” is approximately $150 billion. Like you, corporations may have extra cash to invest. In this case, you, as a finance manager, are considering investing $50,000 in either a Treasury bill that you will renew every 6 months or investing in a 5-year Treasury note that you will hold until maturity. Current interest rates are expected to increase.

1. Would you invest in the Treasury bill or Treasury note? Discuss your reasoning.

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Explanation / Answer

Bond prices is inversely proportional to interest rates so if interest rates are expected to increase, bond prices are expected to fall. One should choose the instrument whose price will fall the least or has least interest rate risk. We know least interest rate risk is for lowest duration. For a bond renewed in 6 months the duration will be 0.5 and for a 5 year note bond will be close to 5 years. Hence interest rate risk is least for 6 month Treasury Bill. In other words, if one invests in 5 year note he will be locked with lower rate despite market rates have risen. But if one invests in 6 month renewal bond the interest rate which he will get will change every 6 months so he will get market rates and will not be locked with lower rates for long which would happen in 5 year note.

So one should invest in 6 month Treasury bill.

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