Risk and The Treasury Bill

- Investors Avoid Risk, Embrace Treasury Bills

Risk versus reward: at the end of the day, it's what investing is all about. Minimize risk, maximize profits. But in the quest for profits even the most sophisticated investors can make assumptions and overlook subtle shifts in risk that can mean the difference between profit and loss.

The ubiquitous Treasury bill may seem to be a slow-moving mastodon amidst the charging herds of volatile stocks, but attentive investors will see trends in T-bill yields and position themselves accordingly. Over the past four years, the discount rate of the four-week T-bill has risen and fallen in a steady arc. In early January of 2004 the discount rate was at a cyclical low of .72%, and a year later had crept up to 1.91%. In January of 2006 the rate was 3.97%, and a year later hit 4.66%.

VaR and volatility of yield curve futures.

From there the arc began its bend toward lower returns, and in December 2008 reached zero. You pay a dollar, and four weeks later you get your dollar back. In one day-Tuesday, December 9-investors scrambling for a safe haven for their cash bought up $32 billion in four-week bills at a virtually unprecedented yield of zero percent, and auction demand briefly pushed the yield on the three-month bill below that mark.

To put this into perspective, Fed data shows the last time yields hit zero was in February 1941. Typically yields hover in the five- to eight-point range. Cycles can be occasionally deep; in July 1958 the yield for 3-month T-bills was below one point. Over time yields rose and fell, but it wasn't until forty-five years later, in June 2003, when yields once again dropped below one percentage point. During this period the cyclical high of 16 points was reached in March 1980.

Flight to Quality

When investors believe that buying unglamorous T-bills is the investment of last resort-as they did back in March of 1980-yields rise as demand falls. But when investors perceive that the risk in the securities marketplace is unacceptable, just finding a safe place to park your cash becomes a prudent investment strategy. It's the Wall Street equivalent of stuffing your greenbacks into your mattress, and knowing that you've made a sensible choice by minimizing your risk.

Chart of volatility of different yield curve maturities generated using the RiskAPI_Volatility function.

It's all about the flight to quality: investors moving their capital away from positions with unacceptable risk to the investment vehicles offering acceptable risk. During a bear market investors will often move their money out of equities and into government securities and money market funds, or move investments from high-risk countries with political unrest and volatile economic conditions to less risky markets of other countries. One indication of a flight to quality is the increased demand for government securities with a resulting dramatic fall of their yield. In extraordinary cases, such as the current investment climate, for some investors the only acceptable risk is zero risk.

For information on powerful risk-management tools that will allow you to track and measure the risk of yield curve instruments, contact PortfolioScience today.

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