Facts About Floating Rate Notes

The Treasury announced it will soon be issuing a new note—what does this mean for investors?

The New Year is almost here. To many, that means it’s nearly time for new resolutions, new calendars or maybe a new hairdo. For investors, 2014 also brings a new investment option. On January 29, the Treasury will issue its first Floating Rate Notes (FRNs)—bonds whose interest payments rise and fall along with the market. Financial innovation! So what does this news mean for investors and Treasury markets?

Though FRNs are new to the Treasury, they aren’t new to the investment world. Many corporate bonds have floating (aka variable) rates, and so do securities from government agencies, like Fannie Mae and Freddie Mac. But Fannie and Freddie haven’t issued many in recent years, leaving a small gap in the market—floating Treasurys can help fill the void a bit. Typically, the coupon is pegged to an indexed rate, like LIBOR or short-term Treasury rates, plus a fixed spread. For example, a floating corporate bond might pay LIBOR plus two percentage points. The Treasury won’t announce the final points of the new FRNs’ pricing until January 23, but they did say the initial notes will have a two-year maturity and be indexed to the 13-week T-bill discount rate. The Treasury plans to issue between $10 and $15 billion at the first auction and an average of $30 billion per quarter going forward.

Why the switch to floating rates? Investors are convinced interest rates will rise over the foreseeable future. Theoretically, this could make fixed-rate Treasurys look a touch less attractive—since bond prices fall as interest rates rise, investors may not see as much benefit. A floating-rate bond is a small insurance policy against rising interest rates, which would help the Treasury head this off at the pass. Not that the Treasury needs sales gimmicks to keep demand alive and well if interest rates rise a bit—many other factors make Treasurys attractive to US and foreign investors—but who can blame them for wanting to jazz things up now and then?

This isn’t the first time the Treasury has offered new products to try and goose demand under certain financial conditions. It has just been a while—since 1997, when they introduced Treasury Inflation-Protection Securities (TIPS). Inflation fears weren’t sky-high at the time, but the product proved popular and had staying power. FRNs, like TIPS, give fixed income investors another option and make US capital markets that much more diverse. That doesn’t mean FRNs are surefire bets—like all bonds, they’ll have their own risks—but choice is good.

As for the debt service side of the equation, FRNs should have a negligible impact. The $120 billion in FRNs the Treasury expects to issue next year amounts to roughly 0.7% of the US’s current $16.7 trillion debt load. So only 0.7% will be subject to variable rates. Low interest costs are locked into the rest, and the Treasury is still refinancing most maturing debt at lower rates.

Overall, a $120 billion-per-year new Treasury offering may be a small drop in the bucket, but it’s an interesting one—a timely reminder capital markets are always evolving.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.