The Treasury’s New Floating Rate Notes: Here’s What You Need to Know

(August 10th, 2012) On Wednesday of last week the Treasury announced that it will be introducing floating rate notes, the first new type of treasury security since Treasury Inflation Protected Securities (TIPS) were introduced in 1997.  Here’s what you need to know.

 

What is a Floating Rate Note

Its a security which, instead of a paying a fixed coupon like most bonds, pays a coupon which fluctuates based on some underlying index.   For example the coupon could be tied to the Consumer Price Index which is a measure of inflation.  If the consumer price index increases so would the coupon payment of the floating rate security which is tied to that index.  The Treasury says they have not decided on which index will be used, but are looking closely at an index called the DTCC GCF Repo index.  This is an index that is basically designed to fluctuate along with movements in the short term interest rates that large non-government borrows charge each other.  (If you want the full explanation go here)  Initially the Treasury is talking about issuing notes with maturities going out as long as 2 years.

 

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The  US Treasury has been looking at the potential for issuing this type of security for over a year now.  However, most analysts did not expect them to go ahead, so the announcement caught many by surprise.  The Treasury says that the first issue is at least a year off, as there are significant changes that need to be made to systems to support the new type of debt.

 

Why is the Treasury going to start issuing floating rate notes?

The consensus, as you can see from the chart below, is that currently too much of the Treasury’s outstanding debt is in short maturities.

Source: Pyramis Global Advisors

The Treasury believes they will be able to shift demand for T-Bills To longer term debt with floating rate notes

Many investors buy short term T-Bills because they are free from default risk and (because they are very short term) they provide protection against duration risk (the risk that interest rates will rise and their investment will lose value).  Because the coupon interest rate on floating rate notes will adjust upward when interest rates rise, they should have no duration risk.  (With a normal fixed coupon rate note or bond, the value of the bond will fall when interest rates rise.)  So instead of buying short term T-Bills, holding them until their short term maturity date, and then buying more, investors can buy the longer term floating rate notes.

By shifting more investors into longer term debt via the new floating rate notes, the US Treasury protects themselves from rollover risk.  This is the risk that there will be a market disruption which would cause the Treasury problems when issuing new debt to refinance short term debt as it matures.

 

Some people aren’t so sure

There are some skeptics however who don’t believe floating rates notes are in the US public’s best interests.  Chief amoung them is the popular Reuters blogger and Counterparties.com editor Felix Salmon who said recently:

“The Treasury has made the decision in part due to the recommendations of the Treasury Advisory Borrowing Committee (TBAC), made up exclusively of members of the financial industry.

Continuing in the mode of offering self-serving advice that would be bad for Treasury, the TBAC recommended that Treasury use the new GCF index as the reference rate for FRNs.  This would put Treasury in a position of taking on private credit risk, since, if we had a 2008-style meltdown and general collateral (rates) widened out due to counterparty risk, Treasury’s FRN borrowing costs would soar.

Good luck to any Treasury Secretary who would have to explain that to the House Oversight Committee.  That sounds like a one-way ticket to a forced resignation.”

The Treasury Advisory Borrowing Committee is made up of some of the world’s largest banks and asset managers.   As Felix points out, they may not have the best interests of the US Treasury in mind when making their recommendations.  Since the GCF index ( the index that the Treasury is considering basing the new floating rate notes on) is based on interest rates that non government borrowers charge each other, it exposes the US Treasury to fluctuations which it would normally be isolated from.  For example, if there is another “panic” in the markets like we saw in 2008, then government borrowing rates are likely to fall as investors park their money in US Government Bonds which are free of default risk.  At the same time, private borrowing rates (like the ones which the GCF index is based on) are likely to soar.  Why would the US Treasury which is a government entity want to expose themselves to this risk?

Another question that many in the market are asking is why would the US Treasury want to expose themselves floating rate debt when they have having no trouble selling debt at all time record low rates?

Regardless of whether or not this is a good idea for the Treasury, I think everyone agrees that this will be a nice option for investors.  It gives investors who would normally miss out on a higher rate because they are concerned about duration risk, a nice alternative option.  Have a question or comment on floating rate notes?  We’d love to hear from you in the comments section below.

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