Gyroscopic Investing

I just bought a 1-year T-bill through my Schwab brokerage window, and I noticed something that looked a little weird to me.

My understanding is that the high liquidity of the Treasury market means that any Treasury security (T-bill, T-note, or T-bond) maturing in 1 year should have approximately the same market yield as any other such security. Thus, if I look at a list of available Treasuries maturing on exactly the same day in October 2013, they should all have pretty much the same yield. If they didn't, people would tend to choose the ones with higher yield, thus arbitraging away the difference.

However, in Schwab what I noticed was that all of the T-notes maturing in 1 year had a consistently higher yield to maturity (YTM) than the T-bills maturing in 1 year. The former had a YTM of about 0.2%, whereas the latter had a lower YTM of about 0.16 or 0.17%. Not a huge difference, I know, but it was a consistent one. The T-note YTM values were very tightly grouped around 0.2% and the T-bill YTM values were very tightly grouped around 0.16-0.17%.

Anyone care to explain this?

Tortoise,

It's because of taxes.  The T-note has a higher coupon and will throw off a larger chunk of cash, which will be taxed as regular income.  If buying in a tax advantaged account then it's better to buy the T-note.  If in a taxable account then it doesn't really matter.

When a T-bill matures, isn't the difference between its face value and its (lower) purchase value taxed as interest, just like the twice-yearly coupon payments from a T-note are? If so, then it seems like the tax treatment of the two should be very similar--both have taxable interest.

Tortoise wrote: When a T-bill matures, isn't the difference between its face value and its (lower) purchase value taxed as interest, just like the twice-yearly coupon payments from a T-note are? If so, then it seems like the tax treatment of the two should be very similar--both have taxable interest.

That's true, but the T-note pays you more interest and then results in a capital loss at maturity (since it was originally purchased at a premium to face value).  This means the overall final income will be the same, except the T-note has more income taxed as income.

This site has a good example which lays everything out (note: RRSP is the Canadian equivalent of 401k):

http://www.taxtips.ca/personaltax/inves ... /bonds.htm

Ok, so it appears that the taxable income formula on that web page ("taxable income = interest income + 50% of capital gain or loss") is the key to understanding why taxable investors should prefer T-bills over T-notes for a given maturity date.

So that's kind of interesting that tax-sheltered investors get a small "free lunch" by choosing the T-note with the highest YTM for the desired maturity date. Unfortunately I picked the T-bill this time (it's in a tax-sheltered account), but next year when it matures I'll remember to buy the highest-yielding 1-year T-note to earn that extra sliver of yield

Thanks for the explanation, Gosso!

Glad to be of help.

In general I don't believe it matters too much in a taxable account, since the price will reflect the tax (dis)advantage.  However, in a tax-sheltered account then I always go for the highest yield-to-maturity...can't say "no" to a free lunch, even if it is only $4/year per $10,000.