How Does a Treasury Bill Work?
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Treasury Bills Are Like Short Term Bonds
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Treasury Bills, or T-bills, are a type of treasury security that the U.S. government can sell to individuals to fund its debt. T-bills are similar to treasury notes and bonds; the distinction is that T-Bills are short term investments that last anywhere from 4 weeks at the shortest to 52 weeks at the longest. Since the term of a T-bill is a year or less, it does not pay interest like a bond, but instead pays a set amount at maturity that is higher than the initial amount paid for the bill.
Return on Investment
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When a T-bill is purchased, the amount that the bill pays at maturity is determined in advance, and the bill is issued at a discounted price. The difference between the discounted price and the price to be paid at maturity is the profit, or return that the investor will receive. For example, Tom might buy a 1,000 dollar 13 week T-Bill for 990 dollars. After he holds the bill for 13 weeks, the government pays him 1,000 dollars for the 990 dollars he lent them. Since T-bills often last less than a year, calculating an annualized return on investment requires the final profit amount to be converted into a yearly rate. In the example, Tom made 10 dollars in 13 weeks, or 1 percent on his investment. Since 13 weeks is only a fourth of a year, Tom's annualized return on investment would be four times that, or 4 percent. The shorter the duration of the T-bill, the smaller the discount will be.
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Why Invest in T-Bills?
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T-bills are useful investments for several reasons. First, they are very safe, perhaps the safest investment that can be made, since the only thing that can prevent them from being paid is the failure of the U.S. treasury before the maturity date. Since they are a short term investment, they can be used as a place to earn a return on money that is not needed immediately. Additionally, T-bills present a safe haven for capital to weather spells of poor market performance and uncertainty that doesn't lock up money too long and doesn't have limits like FDIC insured savings accounts.
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