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Author of blog, David Enna is a long-time journalist based in Charlotte, N.C. A past winner of two Society of American Business Editors and Writers awards, he has written on real estate and home finance, and was a founding editor of The Charlotte Observer's website. The Tipswatch... More
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  • The New Treasury Floating-Rate Notes: Why They Look Like A Bad Deal 0 comments
    Nov 6, 2013 11:03 PM | about stocks: TIP, TIPZ

    The Treasury Department said today it will hold its first Floating-Rate Note auction on Jan. 29. These 2-year-term FRNs are a new product, and are drawing a lot of attention as a possible replacement or add-on to fixed-income holdings like TIPS and I Bonds.

    Floating-rate notes are the first new debt product from the U.S. government since 1997. Should you plan to invest in them?

    TIPS and I Bonds have a special place in portfolio allocation because they 1) are super safe, 2) provide a rate of return that usually is equal to or better than nominal Treasurys of the same term, and 3) provide insurance against unexpected future inflation.

    FRNs will also be super safe and will provide insurance against an unexpected future rise in interest rates. But will they outperform similar-term Treasuries or other safe investments of similar terms? Very possibly not.

    What is an FRN? The Treasury says: "An FRN is a security that has an interest payment that can change over time. As interest rates rise, the security's interest payments will increase. Similarly, as interest rates fall, the security's interest payments will decrease." Read the Treasury's term sheet for FRNs.

    So it is important to note that inflation is not part of the picture for FRNs. While TIPS and I Bonds are tied to future inflation, the FRN is tied to future interest rates, specifically short-term rates.

    What will be the index for FRNs? The Treasury says, "FRNs will be indexed to the most recent 13-week Treasury bill auction High Rate, which is the highest accepted discount rate in a Treasury bill auction." Depending on demand at auction, the FRN could end up yielding a few basis points more than the 13-week Treasury.

    The current 13-week yield is 0.05% and the current 2-year Treasury yield is 0.32%. So even if buyers of an FRN get a 15-basis-point premium (too generous?), they'd be giving up 12 basis points in anticipation of higher shorter-term rates in the future.

    It's important to note that short-term Treasury yields have actually declined in the last year while longer-term Treasurys have seen yields rise nearly 100 basis points.

    • On Nov. 6, 2012, the 13-week yield was 0.10%, now it is 0.05%, a decline of 5 basis points.
    • On Nov. 6, 2012, the 2-year yield was 0.30%, now it is 0.32%, an increase of 2 basis points.
    • On Nov. 6, 2012, the 10-year yield was 1.78%, now it is 2.69%, an increase of 91 basis points.

    The point is: Either way, with an FRN or a 2-year nominal Treasury, you are getting an awful return, well below likely inflation.

    For example, let's say inflation averages 2.3% over the next two years and short-term interest rates rise 25 basis points during that time. You are making a two-year investment today (pretend that FRNs are now being issued at a 15 basis-point premium over the 13-week Treasury). Here is what you could expect:

    • FRN. Over two years your yield will rise to about .45% and you will trail inflation by at least 1.85% a year.
    • 2-year Treasury. Your yield will be 0.32% and you will trail inflation by 1.98%.
    • 2-year bank CD. Your yield will be 1.10% and you will trail inflation by 1.2%.
    • I Bond. Your yield will beat inflation by 0.2% (the current fixed rate on I Bonds). But you will pay a three-month interest penalty if you sell after 2 years. That will drop your return to about 2.18%, just about equal to inflation.

    So, I am thinking the FRN looks unattractive for the average investor. In fact, I don't think it is meant for individual investors at all, as noted in this Financial Times story:

    "Demand for the new floating rate security will come from money funds, short-term funds and corporate Treasurers who want something that is a hedge against rising interest rates and is high-quality collateral," said Ira Jersey, strategist at Credit Suisse. ..

    "For companies that sell floating rate debt, the arrival of a new Treasury security stands to create a new benchmark for this area of fixed income and, over time, encourage a move away from using the London interbank offered rate as a floating reference rate."

    A PIMCO analysis of FRNs came to a similar conclusion:

    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.

    - Follow TipsWatch on Twitter: @tipswatch

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Stocks: TIP, TIPZ
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