This article first appeared in Institutional Investor on June 14, 2013.
Investors have a new form of government debt to look forward to. Later this year or early next, the U.S. Treasury is scheduled to issue its first new form of security since Treasury Inflation-Protected Securities (TIPS) in 1997: Treasury Floating-Rate Notes (FRNs). On May 1, the Treasury announced its intention to issue two-year FRNs. The interest rate will be tied to a 13-week U.S. T-bill auction rate, resetting weekly.
For investors, FRNs will likely offer a hedge against rising rates and a yield pickup over a T-bill. For the Treasury, FRNs could help reduce the “rollover” risk associated with holding auctions, specifically the risk that an auction could fail to attract customer interest, and also help diversify its investor base.
However, because the interest rate resets periodically, FRNs will not allow the Treasury to lock in record-low financing rates and may even expose it to higher borrowing costs in the future. Is this really advisable at a time when unprecedented monetary stimulus may lead to rising rates and inflation? A growing majority of both institutional investors and Treasury officials believe it is.
Why issue them?
Issuing Treasury FRNs sends an important signal to the market: It tells creditors that the Treasury intends to extend the maturity of its debt without punishing purchasers who choose to extend beyond cash equivalents (or T-bills) in a reflationary environment. To explain why the Treasury would do this now, we need to address how this fits its objectives for issuing debt.
The Treasury issues debt when federal expenditures exceed proceeds from tax receipts. However, forecasting cash needs can be difficult, and the willingness of domestic and foreign investors to purchase U.S. government debt may vary. This is especially a concern when the U.S. is running a $640 billion-plus deficit and the Treasury needs to issue that much in securities each year.
In a normal yield curve environment, when long-term rates are higher than short-term rates, the Treasury may be incentivized to minimize borrowing costs by issuing short-term debt. But issuing excessive short-term debt also increases rollover risk. This is because the Treasury may issue larger amounts of short-term debt more frequently as new funding needs arise and previously issued debt matures. If investors suddenly demand a greater premium for holding U.S. debt, the Treasury’s cost of funding may rapidly rise.
So, issuing FRNs could help minimize the U.S.’s short-term cash needs and lower its rollover risk by lengthening the Treasury’s maturity profile. Since the coupon payments will rise along with interest rates, it also assures creditors that extending the maturity profile won’t lock them into low interest rates amid higher inflation down the road.
How will they be structured?
The Treasury reviewed feedback from a broad array of institutional investors, broker-dealers and the Treasury Borrowing Advisory Committee (TBAC) and recently released a draft term sheet for FRNs.
After a lively debate, the TBAC unanimously supported the use of a 13-week T-bill issuance rate. The T-bill index is deep, stable, and easily understood and has a long history, making it appealing to the Treasury. The TBAC did note, however, that this choice of an index does not diversify the Treasury’s funding cost. Additionally, if FRNs become a large component of future Treasury issuance, then T-bill issuance may be cannibalized. However, at this time, the TBAC believes the 13-week T-bill rate is the best choice.
Interest will accrue daily, and the rate will reset each week according to the result of the most recent 13-week T-bill auction, plus a spread, subject to a minimum net yield of zero percent. This minimum is a critical characteristic that should increase FRN appeal in the event the Treasury allows for T-bills to auction at negative rates. Interest payments will be made quarterly.
The auction will be in a single price format in which participants will specify a tender amount and a discount margin. The discount margin is another way of indicating a spread to the T-bill index at which the buyer would like to purchase the T-bills. Like other Treasury auctions, competitive tenders will be accepted starting from the smallest discount margin up to the spread level that will fill the total public offering size. Once completed, the discount margin is set at the highest spread required to fill the auction size and this spread will determine the floating rate of interest the holder of an FRN will accrue for the lifetime of the note.
While many details have been released, the Treasury has yet to specify the frequency and size of the auctions. The TBAC has recommended one opening and two subsequent re-openings in each of the following two months, with an initial auction size of $10 billion to $15 billion. Using this schedule, the Treasury will issue no more than four FRNs per year, which will ensure individual issues are larger and have greater secondary liquidity. We anticipate the Treasury will accept the TBAC’s advice and release a more detailed term sheet next quarter. Lastly, we anticipate that Treasury FRNs will initially replace some T-bill issuance but may eventually become a substitute for some fixed-rate coupon issues in the future as the Treasury looks to issue longer-dated FRNs.
Who will buy them?
Investors who expect unconventional monetary policy to lead to an increase in rates would have an incentive to purchase FRNs as a hedge. However, demand within channels may differ.
Foreign central banks may be natural buyers for FRNs. They currently hold about 25% of the T-bill supply and 40% of the Treasury coupon supply. Rolling T-bill holdings is a core strategy for these risk-adverse investors. So holding FRNs, which minimize roll-related transaction costs, may be appealing.
Corporate cash investors may also find them attractive. Unlike with money market funds, which are limited by a 120-day weighted average maturity (WAM) calculation, for corporate cash investors FRNs may offer a similar duration as T-bills but with a potentially higher yield.
Banks may be slow to adopt FRNs because currently they may deposit excess reserves with the Federal Reserve and earn 0.25%. However, they may find FRNs attractive in the future if the rates on these issues exceed the interest paid on excess reserves. Additionally, as regulators continue to pressure banks to increase the credit quality of their portfolios, FRNs may be particularly appealing given the increasing scarcity of high-quality assets.
Total return (TR) managers, who often manage against a benchmark like the Barclays U.S. Aggregate (BAGG) Index, may present only modest demand for this security as well. FRNs are unlikely to be added to the BAGG index (TIPS are also not included), so TR managers may be slow to adopt them since they won’t have an incentive to purchase simply to maintain a benchmark-like risk-return profile. However, some TR managers may purchase FRNs in order to post these securities as collateral for centrally cleared derivatives; this may be a growing source of demand for FRNs in the years ahead.
Finally, the $2.5 trillion domestic money market industry currently has about 30% of total exposure to U.S. T-bills, so it might be a natural source of demand for short maturity FRNs. However, money market managers will need to weigh the benefits of holding an FRN rather than owning a slightly lower yielding T-bill with a fixed rate. One important consideration for a money fund manager is maintaining a portfolio that has a dollar-weighted average life (WAL) that does not exceed 120 days. Allocating a modest 5% of a portfolio to a two-year FRN will add a significant 36.5 days (365 days x 2 x 5%) to the WAL “bucket.” While most funds subject to Rule 2a-7 of the Investment Company Act of 1940 (which sets requirements for the credit quality, maturity and liquidity of investments) currently have ample room in their WAL bucket, as the FRN program grows, their participation may be limited owing to the WAL constraint.
Will PIMCO buy them?
Like any security available for investment, U.S. Treasury FRNs will be subjected to rigorous analysis. We will evaluate the merits of these securities based on PIMCO’s macroeconomic top-down view and valuation-focused bottom-up analysis. Additionally, we will assess the suitability of these securities based on a client’s objectives and account-specific guidelines.
PIMCO may look to rotate out of T-bills and into FRNs if the yield pickup warrants the extension of average life versus the 13-week T-bill. Furthermore, holding a combination of Treasury coupons (notes and bonds), TIPS and FRNs may allow us to take views on forward nominal yields, real yields and inflation without the use of derivatives. However, prior to purchasing a Treasury FRN, the short-term desk will carefully consider secondary market liquidity.
We look forward to the Treasury’s first auction of FRNs as well as the opportunity to continue to add value for our investors through careful evaluation of this and other investment opportunities.
The authors would like to thank Jerome Schneider and Steve Rodosky for their contributions to this paper.