The amazing ‘moneyness’ of Treasuries

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US Treasury yields are often called the risk-free rate, much to the annoyance of certain finance types.

Yes yes, you can lose money on them, as a lot of investors have rediscovered since 2022. But they remain the dominant reserve asset, and despite periodic Republican nihilism, the creditworthiness of US government debt remains unimpeachable. In a world of dirty shirts, USTs remain the least stinky.

In fact, the reality is that Treasuries are even better than risk-free! Because US bills, notes and bonds are so liquid and so widely used as collateral for physical and financial transactions, people consider them pretty much close to money (especially lower-duration bills).

That means you can very easily convert even billions of dollars worth in Treasuries into cash any time you want. In other words, they’re pretty much like money themselves. And that convenience is something investors are willing to pay for. But how much?

Well, the New York Federal Reserve yesterday published an interesting blog post looking at this. They have reverse-engineered an implicit risk-free rate from S&P 500 index options (the “box rate”), and compared it to the yield of Treasuries.

Here’s what it looks like:

The top panel plots put minus call mid-quote prices for the same strike price and maturity on March 15, 2022, alongside fitted values from an ordinary least squares (OLS) regression. The box rate implied by the slope coefficient from the regression is 1.59 per cent for a maturity in 367 calendar days on March 17, 2023. The bottom panel plots the term structure of box rates from index options of different maturities alongside estimates of Treasury rates from a smoothed yield curve. All rates are zero-coupon discount rates with continuous compounding. Years-to-maturity is actual calendar days divided by 365. The option data is from OptionMetrics for S&P 500 index options with maturities between one month and five years whose bid quotes are greater than zero. © OptionMetrics; Federal Reserve Board

And here is how the box rate and Treasury yields have compared over time. As you can see, USTs have consistently traded about 20-40 basis points below the implied risk-free rate.

The results are similar elsewhere, according to a follow-up paper. But the convenience premium that investors are willing to pony up for Treasuries is arguably the most meaningful, given the dollar’s role in global funding.

It also has very direct and sizeable benefits for the US. The NY Fed’s Jules van Binsbergen, William Diamond, and Peter Van Tassel estimate that it alone has saved US taxpayers about $35bn in interest payments a year over the past two decades, and since 2020 it’s been about $70bn annually.

Which even these days is chunky. It more than covers the entire US foreign aid budget, and over half of the transportation budget.

That’s pretty compelling value-for-money evidence in favour of continuing to stiffen the sinews of the Treasury market.

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