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Interest Rates

U.S. Treasury Securities

The baseline interest rate assumes that there is no risk because it is calculated with reference to government-backed securities.

The U.S. Treasury sells securities. Because these securities are backed by the federal government, the risk of default is extremely low, though not zero. Default risk is the level of risk investors and lenders may incur in the event that a borrower defaults on a loan. These securities are generally considered to be without default risk, or are default risk free. Local municipalities also issue bonds and companies issue commercial paper, but the default risk is different. Because default risk-free securities are highly sought after on the market, government securities carry no market risk. Therefore, the market interest rate is the risk-free rate, which is simply the stated interest rate plus the inflation premium.

The types of Treasury-backed securities are categorized by their maturity levels. At the lowest end of the spectrum is the Treasury bill, also commonly called a T-bill. A Treasury bill is a government security issued by the U.S. Treasury department representing a short-term debt obligation, with a relatively low interest rate and a maturity period within one year. Treasury bills have a maturity of 91 days, with some extending as long as 182 days. These T-bills are sold every Wednesday to make up for the ones that have matured. The Treasury note is in the middle of the maturity spectrum. Also referred to as T-notes, a Treasury note is a U.S. government security that has fixed interest rates and maturities from 2–10 years. They are often purchased by investors through large commercial banks. Last there is a Treasury bond, or T-bond, which is a fixed-interest government-issued bond with a maturity date of over 10 years and up to 30 years. The 30-year maturity is the guaranteed payoff date, but the bond may be callable, or paid off, earlier than this date. Compared to Treasury bills, Treasury notes have a maturity risk, so investors require a maturity risk premium to be added to the risk-free rate to calculate the market interest rate.

Because of the nature of Treasury-backed securities, the government carefully monitors the distribution of the securities. Mid-maturity Treasury notes are the most widely held, followed by Treasury bills. By concentrating most Treasury securities at the low end of the maturity spectrum, the government can rapidly make purchases or issuances that will affect recessionary economics.

Comparison of Bond Types by Maturity

Treasury bills are not the only short-term securities. Local municipalities issue bonds, and companies issue commercial paper, but the default risk is different.
Offering U.S. Treasury securities is one way the government finances debt. These securities are either nonmarketable or marketable. A marketable government security, such as bonds and Treasury bills, offers high quality, liquidity, and marketability. On the other hand, a nonmarketable government security, such as U.S. savings bonds and federal government bonds, is illiquid and difficult to trade. These securities can be, and often are, traded directly with other governments, though U.S. savings bonds can also be purchased by individuals. Foreign governments hold these securities as direct loans payable to the U.S. government. Marketable government securities are traded through the dealer system of brokers where loans are sold to a financial institution or third party as part of the sale of securities. Within the system, large financial institutions purchase and hold the securities for trade. They make their money by selling the security for more than the purchase price.