Treasury Bills and Municipal Bonds: Investment Comparison

Understanding Treasury Bills

Treasury Bills (T-bills) provide a way for the United States government to fund projects by raising money from the general public. The simplicity of T-bills is attractive to investors, who purchase the securities at a price that is less than their face value (par value) and receive a payment from the government for the full value of the bills upon maturity. T-bill securities have a short-term maturity and are issued to mature at three-month, six-month, and one-year maturities (Investopedia, 2015). A primary distinction of T-bills from coupon bonds is when the interest is paid. T-bills pay interest upon maturity, whereas coupon bonds pay interest semi-annually (Investopedia, 2015).

As a money market instrument, T-bills are quite popular in large part because individual investors can afford them, and because neither local nor state taxes are levied on T-bills. While institutional investors commit very large sums to their investments, individual investors can choose from T-bill denominations as low as $1,000. Typical T-bill denominations are $5,000, $10,000, $25,000, $50,000, $100,000, and $1 million (Investopedia, 2015).

Globally, treasury securities (T-bills and the like) are considered to be risk-free investments, topping the list of safe investments, since they are backed by the government that issued the treasuries (Investopedia, 2015). However, this safety comes with a price: returns are low because the investment risk is low. Additionally, investors who cash out before the maturity of the securities may not receive all the money back that they invested when they purchased the bills (Investopedia, 2015).

Municipal Bonds and Tax Benefits

Treasury bills, notes, and bonds are all issued to investors at auction through a competitive bidding process. In order to purchase a T-bill, an investor must submit a competitive or non-competitive bid for the securities (Investopedia, 2015). For bids that are submitted non-competitively, the investor receives the security amount that they have requested, but the return is determined at the auction (Investopedia, 2015). The process of competitive bidding truly is a bid, in that investors specify the return they are seeking and learn if they will receive any securities at all, or if they will receive a portion of their bid (Investopedia, 2015). The determining factor is whether the return specified is considered too high to be truly competitive (Investopedia, 2015). A bid that is too high can eliminate an investor from the auction.

A municipal bond is issued to finance large capital expenditures, such as highway or bridge construction and to build schools. A municipal bond provides tax benefits in that most "munis" are exempt from federal taxes and are also exempt from most local and state taxes, particularly when the investor resides in the state that has issued the municipal bond. As a debt security, municipal bonds are favored by investors in high income tax brackets, fundamentally because of their tax benefits and the low risk of investment.

Investment Risks and Considerations

The information provided up to this point paints a rosy picture for treasury bills. However remote—a consideration viewed as more probable after the 2008–2009 fiscal meltdown—a downside to treasury bills does exist. There is the matter of custody risk: should the custodian (money market fund or brokerage firm) that holds (has custody of) the treasury security investment fail, it is no longer possible to simply get back the securities. In the best case scenario, investors can legally get their securities back, but it could take considerable time. A T-bill is essentially just an IOU—a promise to pay—from the United States government. And like any IOU, it is possible to renege on a T-bill.

Credit ratings are an important investor consideration, and the downgrade of U.S. debt from AAA to AA+ by Standard & Poor's in 2011 was an unexpected development that shook up, but did not disrupt, the ratings community (Prosser, 2013). Neither Fitch Ratings nor Moody's Investor Service downgraded their ratings of U.S. debt (Prosser, 2013). The credit ratings of agencies with bonds linked to long-term U.S. debt, such as Fannie Mae and Freddie Mac, were downgraded right along with the U.S. debt—which underscores the old adage about being known by the company you keep (Prosser, 2013). Long-term U.S. debt had never been downgraded, going all the way back to when S&P commenced credit ratings in 1941 (Prosser, 2013). Overall, the credit downgrade is a reflection of the level of debt relative to the size of the economy, a condition that is not viewed as favorably as when the U.S. long-term debt burden was considerably lower (Investopedia, 2015).

Opportunity Cost and Real Returns

When making a decision to invest in T-bills, comparison with other investment options, perhaps framed as opportunity cost, is important (Merton, 2014). T-bills may be considered a strategy to keep from reducing cash over the short-term, but in real terms, T-bills can cost investors money. From the treasury yield, investors need to evaluate the impact that paying federal taxes has on the return from the treasury securities. In addition, the annual rate of inflation needs to be part of the overall calculation, as it reduces both the principal and the interest. Taken together, the low-risk treasury bills are likely to cost investors in terms of purchasing power (Merton, 2014). Essentially, risk is reduced, but so is absolute return. If too many investors move away from T-bills, the loss of confidence or interest in the treasuries can increase the U.S. government's cost of short-term borrowing, as greater yields are needed to attract investors (Merton, 2014).

When T-bills are considered part of retirement planning, their value needs to be considered in terms of the income stream that they can provide—as this is the value that investors seek (Merton, 2014). A retiree may convert their T-bill investments to an inflation-protected annuity. The principal amount in a T-bill is preserved at all times, but the income stream varies widely as the return on the annuity fluctuates (Merton, 2014). The outcome is that the T-bill-based annuity does not contribute sufficiently to post-retirement living (Merton, 2014).

Conclusion

It seems that T-bills and municipal bonds have the most robust appeal to those investors who find it strongly aversive to pay taxes on their investments, and that this feature has the capacity to turn their head to the point that they may not consider the opportunity cost that results from not using that money to invest in CDs or more volatile instruments. This is not to say that treasury securities or municipal bonds cannot have a place in a diversified portfolio, but that role is decidedly limited.