Bills, Notes and Bonds: Where Benchmark Interest Rates Come From

When people hear that rates are rising or falling, they rarely ask where the number comes from. One of the most important sources of benchmark rates is the market for debt issued by the U.S. government, known as Treasury securities. Understanding the three main kinds, bills, notes and bonds, helps explain why the rates on mortgages and other loans move the way they do.

Key takeaways

• Treasury bills, notes and bonds are loans to the federal government, and the main difference among them is how long the money is lent.
• Bills mature in a year or less and are sold at a discount, while notes and bonds pay a fixed amount of interest twice a year.
• Rates on mortgages and other long-term loans tend to move in the same direction as longer-term Treasury yields, but they are not identical to them.
• A household's own rate also depends on its credit profile, the type of loan, the down payment and the lender, not only on benchmark yields.
• Knowing whether a loan has a fixed or variable rate, and what benchmark a variable rate follows, helps explain why a payment does or doesn't change.

The government borrows too

The federal government funds part of its spending by borrowing. It does that by selling Treasury securities, and the buyers are lending the government money in return for repayment with interest.

These securities are backed by the full faith and credit of the U.S. government, and they are generally regarded as having some of the lowest credit risk available. That doesn't make them risk-free in every sense. The market price of an existing Treasury security can fall when interest rates rise, which matters to anyone who sells before it matures.

Three names, three lengths

The difference among bills, notes and bonds is mostly how long the money is lent. The Treasury's TreasuryDirect site lists the current terms.

• Bill: matures in one year or less. It is sold at a discount, and the full face value is paid at maturity.
• Note: matures in 2 to 10 years. It pays fixed interest every six months, with the face value repaid at maturity.
• Bond: matures in 20 to 30 years. It pays fixed interest every six months, with the face value repaid at maturity.

Here is a simple illustration. A bill with a $1,000 face value might sell for $990. At maturity, the holder receives $1,000, and the $10 difference is the return. Notes and bonds work differently: they pay a set amount of interest twice a year, and the holder gets the face value back at the end.

Why the length matters

Lending for a longer time ties money up for longer and leaves more room for the world to change, including the level of rates and prices. For that reason, longer-term securities often offer higher yields than shorter-term ones, though not always. When the pattern reverses, with short-term yields above long-term ones, it is often discussed in the financial news as an "inverted yield curve."

The yield is the return an investor earns on a security at its current price. When more investors want to buy, prices tend to rise and yields fall, and the reverse is also true.

From Treasury yields to household rates

Households rarely buy Treasury securities directly to borrow money, so why do they matter to a family with a mortgage? Because they serve as a reference point. Investors who fund long-term loans compare the return on those loans with what they could earn on Treasuries. As a result, rates on mortgages and other long-term loans tend to move in the same direction as longer-term Treasury yields.

The link is not one-to-one. Lenders add a margin to reflect credit risk, costs and market conditions, so a mortgage rate is typically higher than a Treasury yield of similar length, and the gap between them can widen or narrow over time.

Shorter-term rates work a little differently. Rates on many variable-rate products, including many credit cards, are tied to short-term benchmark rates that are influenced by central bank policy. That is why a policy change can show up in a credit card's rate even if long-term yields barely move.

What this does and doesn't tell a household

Headlines about Treasury yields can be an early hint about the direction of borrowing costs. They don't determine the rate on any individual loan. That rate also depends on factors such as credit profile, the type of loan, the size of the down payment and the lender's own pricing.

A few questions can help make sense of the news:

• Is my loan fixed or variable?
• If it is variable, what benchmark does it follow, and when does it next reset?
• How much of my budget would a rate change actually touch?

A fixed-rate loan stays the same whatever yields do afterward. A variable-rate loan may change, depending on its terms. As the Consumer Financial Protection Bureau explains for mortgages, an adjustable rate follows a market index plus a lender margin and may go up or down. Knowing which one you have is often the first step toward understanding why a payment does or doesn't move when rates make the news.

Common questions

What is the difference between a Treasury bill, note and bond?

The main difference is length. Bills mature in one year or less, notes in two to ten years, and bonds in twenty to thirty years. Bills are sold at a discount, while notes and bonds pay interest every six months.

Why do Treasury yields affect mortgage rates?

Investors who fund long-term loans compare them with the return on Treasury securities, so mortgage rates tend to move in the same direction as longer-term Treasury yields. The link is not one-to-one, because lenders add a margin for credit risk, costs and market conditions.

Does a rise in Treasury yields mean my own loan rate will change?

Not necessarily. A fixed-rate loan stays the same regardless of what yields do afterward. A variable-rate loan may change, depending on which benchmark it follows and when it is scheduled to reset.

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