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How to Earn Interest on Your Cash Allocation with Low-Risk Treasuries

When large investors have trouble finding great companies to buy or invest in, they’ll see an increasing cash allocation in their portfolio. So what do they do? Most invest in treasuries, and investors can do this with the cash in their portfolios too.

Did you know who is one of the largest players in the treasury market is? Surprise! It is Warren Buffett! Bet you would have never guessed that! I know I was a little shocked, but it makes sense because he has been saying for years that he has had trouble finding companies to either buy or invest in because of the size necessary to move the needle. So he uses Treasuries as a liquid place to store his money until he finds an investment he likes.

Many very famous investors use treasuries as a way to have their cash earn a few bucks while keeping it fairly liquid in case there is an opportunity that presents itself.

Today, we are going to discuss in-depth Treasuries ranging from:

  • Bonds, bills and notes
  • What they are
  • Are they worth investing in?
  • How to purchase them
  • Discussing ladders, what they are, and how to use them in a cash allocation strategy to stay liquid while still earning interest.

Let’s take a moment and look at the size of the bond market. Currently, as of Jan 13, 2020, the bond market is valued at $42.8 trillion, of which treasuries account for $15.6T, with corporate bonds valued at $9.2T, and mortgage-backed securities at $9.7T.

Compare this to the nearly $20 trillion for the domestic stock market, and you get a picture of how big this market is and how much of an impact it can have on our economy and the world.  

Based on the size of the market and the possible benefits you could reap from treasuries, I think it bears learning a bit more about this market.

So, let’s dive in.

What are Treasuries?

Treasuries, for those not familiar with them, are government debt. Pretty simple, huh?

Ok, let’s dive a little deeper.

According to Investopedia:

“U.S. Treasury securities—such as bills, notes, and bonds—are debt obligations of the U.S. government. When you buy a U.S. Treasury security, you are lending money to the federal government for a specified period.

Because these debt obligations are backed by the “full faith and credit” of the government, and thus by its ability to raise tax revenues and print currency, U.S. Treasury securities – or “Treasuries” – are generally considered the safest of all investments. They are viewed in the market as having virtually no “credit risk,” meaning that it is highly probable your interest and principal will be paid fully and on time.”

One note about treasuries, because of their safety, they usually come with a lower interest rate attached to them because of this safety. There is a bit of give and take when working with treasuries, but the upside is that you gain that safety. Experts like to say that with higher risk comes greater rewards, and I don’t buy that theory. Using treasuries as a safe, secure method of investing can allow one to sleep better at night.

Ok, so that is an overview of treasuries, now let’s dive into the nitty-gritty of each type.

Treasuries come in many different flavors, but the ones we are going to focus on are the three main bonds. Remember that a bond is a loan we are giving to someone, in this case, the US government.

T-bills – They have the shortest range of maturities of all government bonds. T-bills are auctioned on a regular schedule, which you can find the schedule on treasurydirect.gov. There are five terms:

  • 4-weeks
  • 8-weeks
  • 13-weeks
  • 26-weeks
  • 52-weeks

T-bills because they have the shortest duration of any the bonds that the government issues, will have the lowest interest rates available. As a short-term bond, they are perfect for ladders or if you want to earn a bit of money in interest and have the money more readily available than say a bank CD.

So how T-bills work is they are issued at a discount to their par value, and when they mature, be it four weeks or 13 weeks, you would receive the principal back plus the interest.

Let’s look a an example.

If we buy a $1,000 13-week bill for a 0.153% discount rate, the purchase price would be $999.82, a discount of $0.18. The purchase price can be determined from the following formula:

P = F (1 – (d x t)/360), thus
P = 1000 (1- (.00153 x 229)/360), solving

P = $ 999.82
P = Price
F = Face value
d = rate of discount
t = days to maturity

Notes – T-notes represent the middle range of length of bonds that the government issues. These notes come in longer durations, which are available to be sold at auction, just like the T-bills. The lengths for T-notes are as follows:

  • 2-year
  • 3-year
  • 5-year
  • 7-year
  • 10-year

As with the T-bills, the schedule is available at treasurydirect.gov; the notes can be purchased either by auction or by buying directly on the government website, accepting the yield they are offering. More on this in a moment.

T-notes are issued at increments of $100, with the minimum being $100, and they mature at the same price, with their interest paid semiannually. Currently, the 10-year Note is yielding 1.88%. Again, you can find rates for any duration of T-notes at treasurydirect.gov.

As a side note, 10-year notes are the standard rate we use when calculating any discounted cash flow or intrinsic value calculation.  

If it seems like I am an ad for the government website, it truly is a fantastic resource to learn more about all treasuries, as well as a place where you can manage your treasury portfolio in totality. And I receive no money for any of these recommendations, this entirely my own opinion and based on the ease of use I have found.

Bonds – T-bonds are the long-form for any treasury bonds. Issued in length of 30 years and pay interest every six months until they mature. When the T-bonds mature, they are paid at its face value, plus they are issued in $100 multiples. The current rate of the 30-year T-bond as of January 30, 2020, is 2.33%.

We can find rates for all treasuries here:

  • 1 month – 1.53%
  • 2 month – 1.55%
  • 3 month – 1.54%
  • 6 month – 1.57%
  • 1 year – 1.56%
  • 2 year – 1.58%
  • 3 year – 1.59%
  • 5 year – 1.67%
  • 7 year – 1.79%
  • 10 year – 1.88%
  • 20 year – 2.19%
  • 30 year – 2.33%

The above is just a sample of the data available on the treasury.gov site. What is cool is that you can see the ups and downs of the rates daily.

There are multiple other types of treasury securities, such as EE bonds, I bonds, TIPS, and so on. But we are going to focus on the three that we can possibly use in our investing plan.

How to Invest In Treasuries?

All three types of Treasury securities can be purchased online at auction in $100 increments. Depending on the treasury you are trying to buy, there will be different schedules for each type, bills, notes, or bonds.

Any of the treasuries can be purchased either through your broker/bank or directly on the government site. The purchases are made through an auction process. The auction happens on different schedules, depending on the type of security you are purchasing.

How the auction process works via treasurydirect.gov:

“You can bid for a note in either of two ways:

  • With a noncompetitive bid, you agree to accept the yield determined at auction. With this bid, you are guaranteed to receive the note you want, and in the full amount, you want.
  • With a competitive bid, you specify the yield you are willing to accept. Your bid may be: 1) accepted in the full amount you want if your bid is less than the yield determined at auction, 2) accepted in less than the full amount you want if your bid is equal to the high yield, or 3) rejected if the yield you specify is higher than the yield set at auction.

To place a noncompetitive bid, you may use TreasuryDirect, a bank, or a broker.

To place a competitive bid, you must use a bank or broker.”

That spells it out much better than I could. I use the non-competitive bid option as it makes it much easier for me, but in the future, I might explore bidding on my own as I get more comfortable with the process.

The biggest advantage that treasuries offer is the safety of principle. With the backing of the US government, their full, faith, and backing help give treasuries a great sense of safety. Remember what Warren Buffett likes to say, never lose your principle, that is the greatest advice to any beginning investor.

But, like any investment, treasuries do come with some risks and downsides.

Treasuries are extremely sensitive to both inflation and changes in interest rates; this is why if you are investing in treasuries, you need to be aware of the current interest rate environment.  

Interest rates paid to all treasuries are among the lowest in the securities investments, partially because of the debt they are tied to, also because of the safety that they imply as well. Typically, any treasury will pay a better interest rate than most money-market funds or bank products, such as a savings account or CD.

With the rates pushed down as low as they are currently, there are online banks that are offering rates that might be comparable; however, the treasuries offer relatable rates and in the case of CDs, more liquidity.

I have found that using treasurydirect.gov is the simplest way to invest in T-bills, mainly because they allow you to purchase them in increments of $100 where my brokerage accounts at Ally and Charles Schwab require at least $1,000 to purchase them.

Also, setting up your account at treasurydirect.gov is quite simple, you link your bank account and then transfer the money, and then you are ready to go. Once any of your treasuries mature, you can either reinvest them or transfer the money back to your bank account automatically. It is quite simple and easy to use.  

With the elimination of brokerage fees, purchasing any bond is free, like buying a stock.

There are taxes to think of when investing in treasuries, just like stocks. I know no one is excited about taxes, but it is a detail that we must consider when investing.

The same tax rules apply for all three types of Treasury securities. The interest paid on T-bills, T-notes, and T-bonds is fully taxable at the federal level but is tax-free for states and localities. And if you hold your securities with the US government site, the amount of interest you earn is easily seen on the website. Additionally, the Treasury Department sends our 1009-INT form directly to us, whereas we will have to contact our bank or broker to gather that information.

Yucky, I know but on a need to know basis, and we need to know.

Bond Ladders: What They Are and How to Use Them

To build a bond ladder, you purchase bonds, typically individual securities, but also possible with funds. You do this by staggering your maturity dates so the bonds mature at different times.

We can utilize this strategy with treasury securities as well as corporate bonds, and municipal bonds. It is a cash allocation strategy that I use with T-bills in my emergency fund.

So, how do we make a bond ladder using treasuries?

Creating a bond ladder is pretty easy, and there are three steps to the process. Think of how a ladder is constructed, using rungs, the height of the ladder and the space between each rung. These are our steps:

  • Rungs: Invest in a range of bonds with different maturity dates. You should select the number of bonds, maturity dates, and yields that you want for the cash allocation of your portfolio. 
  • Heights: Hold each bond or fund until it reaches maturity, collecting interest payments along the way.
  • Spacing: Once each bond or fund matures, we can choose whether to reinvest in our ladder or use the funds elsewhere. 

The rungs of the ladder are your bonds or fund. We can determine how many bonds we need by dividing the total dollar we want to invest by the length of time we want the ladder to last, of course, if you don’t have a ton of money to start you can build it up by using the treasury website to start creating your bond ladder with treasuries. Using t-bills as a starting point is an easy way to get the hang of building a ladder and the amount required to start is far smaller than buying either corporate bonds at $1,000 each or buying from your broker.

The height between each rung represents how close our bonds are to maturity. This can range from every few months to several years, depending on the types of bonds we choose — T-Bills for shorter goals, notes for medium goals, and bonds for longer-term goals.

In today’s environment of low interst rates, using a ladder will help you build a safe portfolio that can grow your money over time. Most experts recommend longer ladders as they tend to produce higher income because bonds with longer maturities typically offer higher yields. Shorter ladders can reduce the returns, but on the other side of the coin, they offer less reinvestment risk and increases our liquidity.

Depending on your goals and what you want to achieve with them, will help you design your ladder to meet those goals.  

Using shorter maturing T-bills is why I have created a ladder using T-bills, the liquidity meets my needs in case I ever need it.

An example of a bond ladder using T-bills:

  • 4 – weeks       
  • 8 –  weeks
  • 13 – weeks
  • 26 – weeks
  • 52 – weeks

Let’s say we invest $500 in each rung of the ladder, then every four weeks, the first rung is going to mature, giving me access to the initial $500 investment, plus any interest earned. And likewise, for each rung, i.e., 8 – weeks, 13 – weeks, and so on.

The above is a simple example, but you can certainly use this strategy with longer-maturing bonds such as T-notes and T-bonds.

We can set up our ladder to be recurring, both so it continues to grow it’s interest payments, and provide us with liquidity if we need it.

Now, as with any investment strategy, there are a few pros and cons that I must make you aware of before going on.

  • Pros
    • Bond ladders can create predictable streams of income – Unlike investing in stocks, we know what we will receive in regards to our principal, and the date and amount of our coupons that we will receive.  
    • Bond ladders can smooth the possible impact of interest rate fluctuations – With the ability to stagger the maturities of our bonds, we can smooth out the ups and downs of the interest rate environment. If the interest rates are higher, we can reinvest at higher rates when our bonds mature. And vice versa, if rates are lower, we can choose other options. Plus, we still have other bonds earning higher rates until they mature.
    • Bond ladders greatest benefit, they provide flexibility – I think the greatest benefit is the flexibility that bond ladders provide us. Particularly in regards to government treasuries, with the ability to great ladders with smaller amounts to begin. You have the ability to continue to invest with greater amounts to build up your ladder. Also, with the differing maturities available, it gives you flexibility to build a ladder to meet your needs, whether it be saving for a new car/house, emergency savings account, or you just want to have some money in a more secure place.
  • Cons
    • Bond ladders do not eliminate all risk – No investment is 100% guaranteed, including a bond ladder.  Bonds are only as strong as the underlying company’s credit, they can default, although that is rare. This is why using government treasuries can provide more safety because they don’t default. When working with corporate bonds, utilizing credit agencies ratings such as Moody’s is far more crucial.

The ladder strategy helps to maximize its benefits. Since there are multiple bonds with staggered points of maturity, bonds are constantly maturing, producing yields, and freeing their principal for reinvestment or other uses. Of course, bond ladders only work if you hold the bonds until they reach maturity. Selling the bonds early or changing investment strategies expose you to additional risks and defeat the purpose of the ladder.

Final Thoughts

Many investors and institutions utilize treasuries as a part of their investing strategies, both as a storehouse for cash and safety. Many of the investors that we look up to hold t-bills as a short-term way to make some money on their cash while waiting for other opportunities to invest in the stock market. With the lower interest rate environment currently locking any money up in a long-term bond is not necessarily something you might want to do when you do that, you run the risk of not beating inflation over the life of that bond.  

Another benefit for fixed-income investors who live in states with high-income tax rates can also benefit from the tax exemption of Treasuries at the state and local levels.

After all, even investors as sophisticated as Warren Buffett use treasuries in Berkshire Hathaway. And I figure if they are good enough for him, it might benefit us to learn more about these investment vehicles. Next time you look at a balance sheet on a 10-k, notice that it says cash and cash equivalents. Surprise, those cash equivalents are most likely treasuries.

I have found in my travels that once we peel back to the veil of unknowing, we can find some great ideas and possibilities to grow our knowledge. And after all, knowledge is power.

I hope you found some value in this article, and it helps you on your investing journey.

As always, thank you for taking the time to read this article, and if you have any questions, please let me know.

Take care,

Dave