A lot of startups are finding that, with interest rates going up, they have the opportunity to work with a cash management specialist who can then get them into very safe Treasury and corporate bonds, even packages or bundles of bonds.
These types of bonds are different to simply putting your cash into savings or a money market account because it takes a little more work, but you also get a higher yield. A cash management team can do a lot of the extra work for you, and more startups are finding themselves holding Treasury securities or high quality corporate bonds such as Starbucks or Google. Treasury securities include Treasury Bills, which have maturities of less than a year, Treasury Notes, which have maturities of two to 10 years, and Treasury Bonds, which have maturities of 20 or 30 years. Bills, Notes, and Bonds all pay a fixed rate of interest during the life of the security. Realistically, an early-stage company would only buy Treasury Bills or occasionally Treasury Notes, since a startup needs to keep their capital accessible.
Treasury Bills (T-Bills) differ from other Treasury securities in that you don’t get interest until the bond matures. Investors typically buy these bonds at less than face value. So you might pay $980 for a $1,000 T-Bill, and you’ll get $1,000 if you hold it to maturity. The difference between what you paid and the face value of the T-Bill is your “implied interest.” You’re getting 2% interest, since $980 is 98% of $1,000.
What Happens if you Need to Liquidate Treasuries Early?
But even with very short-term Treasuries, it’s possible a startup might need the cash sooner than expected. If you had to sell your bonds early, do you risk losing any of your principal? We have had a client at Kruze Consulting ask us this question recently and it’s a really good one.
You’re faced with two alternatives:
- Hold to maturity. If you don’t have to sell those bonds, and you can just hold them to maturity, you won’t risk a loss of principal. You will get paid back as you normally would and you will receive your interest.
- Sell at as discount. The other option is that Treasuries can be sold at a discount.
In our example above, you’re getting a 2% interest rate. Suddenly, interest rates go up to 5%, which is a huge increase. Your bond is worth a lot less. At this point, if you try to sell it, you are going to have to sell it at a discount for less than the $980 you paid for it. That’s because other investors can buy new T-Bills yielding 5% now, so there’s no incentive for them to buy your 2% bond. You’ll need to sell it for less than the $980 you paid to find a buyer. This is where the risk of losing principal comes into play. And that’s why startups need to match the maturity dates on their bonds with the dates they need cash. Your cash management specialist at your startup bank can help you.
Being able to buy Treasuries at a discount actually protects you from the risk of losing principal. Although you are still effectively losing a type of value when interest rates go up, you can mitigate that by holding it and then getting paid out with the nominal amount of cash or nominal interest rate.
The bottom line is, because you are buying at a discount the whole concept of a loss of principal isn’t as applicable. You can always hold the Treasury until maturity and get your original investment and the interest.
By the way, if interest rates start to go down again, you will then be making money on your Treasury bond. It is the same process as when you make a loss if the interest rates go up, but in reverse. When interest rates go down, your bonds are actually worth more and they will start being sold for above par. This means you will then be making a profit on them.
Interest rates and bond values move inversely
When interest rates change, bond values often move in the opposite (inverse) direction. Reasons for this include:
- When interest rates rise, bond prices usually fall, and vice versa. The reason (outlined above) is that when interest rates go up, investors will naturally buy bonds that are paying the higher interest rates. So the value of existing bonds, that are paying the lower interest rate, goes down. Anyone who tries to sell one of the older bonds with the lower interest rate is going to have to drop the price to find a buyer.
- When interest rates fall, a bond’s price usually increases. A bond’s coupon rate is fixed when issued, representing the interest payments it will make annually as a percentage of its face value. If the bond’s coupon rate is higher than the current market interest rate, the bond becomes more attractive, and its price increases. Conversely, if the market rate rises above the bond’s coupon rate, the bond’s price tends to decrease.
- Another factor is the bond’s yield to maturity (YTM), YTM reflects the total return anticipated on a bond if it is held until it matures. When interest rates rise, newly issued bonds offer higher yields, making existing bonds with lower yields less desirable. As a result, the prices of existing bonds decrease to align with the new higher yields, causing the YTM of existing bonds to increase.
- Duration sensitivity is another reason for bond price fluctuations. Bonds with longer maturities are more sensitive to interest rate changes than those with shorter maturities. This sensitivity is measured by a bond’s duration, which calculates the bond’s price sensitivity to interest rate changes. Longer-duration bonds experience greater price changes in response to interest rate fluctuations. This is one reason that startups, which typically have a short investment timeline, should focus on Treasuries that have short maturities.
Overall, understanding how interest rate changes affect bond values helps startup founders and CEOs make informed decisions about their cash management strategies, as these changes can impact bond prices.
Avoid losses on Treasuries with a cash management plan
Startups need to think carefully about where they keep their capital and how quickly they can access it. While Treasuries can definitely provide higher yield than standard savings or checking accounts, you have to be careful about locking up your funds. You need to forecast your company’s financials and determine how much cash you need at every point along your runway so you can make sure you’ve got access to it. Treasuries, corporate bonds, certificates of deposit (CDs), and other investments can be structured to mature at specific intervals (called laddering) to make sure you’ve got cash on hand when you need it.
If you have any questions about cash management, startup investing, startup accounting, taxes, or venture capital please contact us. You can also follow our youtube channel and our blog for information on accounting, finance, HR, and taxes for startups!
