A new market is opening up for retail investors, and it may be coming to a broker near you soon. Traditionally the preserve of institutional investors, T-bills offer investors a secure way of storing money in the short term while getting a return in line with current interest rates. So what are T-bills exactly and how do they work?

WHAT ARE T-BILLS?

T-bills are basically short-dated government bonds. They come with a minimum maturity of one day, and a maximum maturity of 364 days, but in reality most T-bill issues have maturities of one month, three months, or six months. Like gilts, they are loans to the government, and so have a very high level of safety, as you are guaranteed your money back unless the UK government defaults on its debt, which is extremely unlikely.

Unlike gilts they don’t come with any income attached, the investment return comes solely from the difference between the price at which the government sells to investors and the redemption price when the government pays them back. So for instance, you might buy a six month T-bill for £98 which will be worth £100 at maturity, in other words a return of 2.04% (£100 divided by £98) over six months. T-bills are not traded on the secondary market, meaning if you buy one you have to hold it to maturity, so you must be willing to give up access to your capital over this period.

WHAT DETERMINES THE RETURN ON T-BILLS?

T-bills are auctioned by the UK’s Debt Management Office on a weekly basis, so the price is set by supply and demand through the bids which investors submit. In reality these are likely to reflect other short term interest rates, and so will be heavily influenced by the Bank of England’s base rate. If the Bank cuts the base rate, this will dampen the returns provided by T-bills at auction. However, if you already hold a T-bill, your return isn’t affected as you will still receive the same maturity value.

WHAT ARE THE RISKS OF T-BILLS?

There is an extremely low chance of the UK government not paying back the money it owes through T-bills, so they are very safe from this point of view. They do come with inflation risk, because inflation might be more than the return provided by the T-bill, which could mean your money actually losing its buying power. This is common to all fixed interest investments, unless they have a specific inflation link attached.

You also face interest rate risk with T-bills. If interest rates rise just after you have bought the T-bill, the return you’re getting might look less attractive by comparison. However, this risk is mitigated to a large extent by the short-dated nature of T-bills. Ultimately if rates rise, you don’t have to wait too long to get your money back, at which point you can put it to work getting a higher return.

Probably the greater risk for T-bills is reinvestment risk, which is the risk you may not be able to achieve a similarly favourable rate when your T-bill matures. If interest rates fall while you’re invested, at maturity you’ll probably get a lower rate if you roll it over into another T-bill. By contrast, if you buy a government bond which is longer dated you lock into the return for a longer period. Depending on how interest rate expectations move, that could end up being better or worse than the return achieved by buying a series of T-bills.

WHAT IS THE TAX TREATMENT OF T-BILLS?

Many people have been buying low coupon, short-dated gilts in recent years, because most of the returns form these instruments are capital gains, and gilts are not subject to capital gains tax. 

It’s important to recognise though that the tax treatment for T-bills is very different. They are taxed as what are called ‘deeply discounted securities’ which means that returns are taxed as income, even though intuitively they look like capital gains. So you will potentially be subject to income tax on your return. Happily though, T-bills can be held in a stocks and shares ISA where the gain can be harvested tax free.

T-bills are an interesting addition to the retail market and an extra tool for investors to keep in their armoury. As ever though it’s important to make sure you understand the ins and outs of an investment before parting with your money.

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