American Flag

A New Type of Treasury

American Flag

The upcoming Treasury auction in January of 2014 will be different from past auctions in that it will mark the debut of a new category of Treasury security, Floating Rate Notes (FRNs). The last time that Treasury introduced a new security was in 1997 with the Treasury Inflation Protected Securities (TIPs).

As its name suggests, a floating rate note has a variable interest rate that regularly resets based on current rates. In this case, the base rate will be the rate on the 13-week Treasury bill, so the rate paid on the FRN will be this rate plus a spread that will be determined at the time of issuance (i.e., from the bids made at the auction). The first FRNs issued will be at a maturity of two years and will pay interest quarterly. It is not yet clear what other maturities Treasury intends to issue.

The advent of FRNs allows investors to make a longer-term investment in Treasury securities while having protection from term risk, the risk that interest rates rise, causing a drop in the value of their bond. Of course, the cost of being shielded from risk is a lower expected return. Just how much lower? That is what we will find out after the spread over the T-bill rate is set at the auction. This lower expected return is similar to what we expect for TIPs which shield investors from the risk of unexpected inflation. For extremely risk-averse investors who are currently buying T-bills and rolling them over, Treasury FRNs would make a lot of sense. They are essentially guaranteed a higher return over their current strategy, assuming the spread is positive. Of course, it may make more sense for them to learn how much risk they can truly handle in order to get an even higher expected return.

As we have said many times, we at IFA are not in the business of forecasting interest rates. Thus, we would strongly discourage investors from buying Treasury FRNs for the purpose of expressing a view that interest rates are “going up”. Likewise, we counsel investors against buying TIPs merely because they think inflation is going to come in higher than what market expects. Our approach to fixed income investing is to take the term and default premiums that are offered by the market up to the point where we do not see any diminishing marginal returns. Thus, we do not anticipate that any of the fixed income funds that we advise for our clients will buy the FRNs.

As a fiduciary for wealth, Index Fund Advisors will continue keep a close eye on new developments in the investment world. If you have any questions about this topic (or any investment-related topic), please feel free to drop us a line at [email protected].