FRNs: Their Time In The Spotlight Is About To End

Includes: TFLO, TIP
by: Tipswatch

FRNs, 2-year investments, have been in the news recently because their yields topped all Treasury investments with terms up to 10 years.

FRNs are attractive during a time of rising interest rates, especially for cash you know you will be holding for two years.

But during a period of declining rates - which could be coming - shorter-term investments give you more flexibility, with just a small yield penalty.

A couple weeks ago, I notice a rather large (for me, at least) deposit drop into my bank account. I wondered: Where did that come from?

After a little research, I realized that a 13-week Treasury that I had been rolling over since February 2017 had matured and paid out. That was an accident; I intended to keep it rolling over, but TreasuryDirect only allows a user to schedule a maximum of seven rollovers of 13-week Treasury bills. I forgot to reset and continue the rollovers. Oops.

Floater But this mistake gave me a chance to analyze my investment choice. Would a Treasury Floating Rate Note, commonly called an FRN, be a better investment option than a 13-week Treasury? These FRNs are a fairly unknown investment, but have been in the news recently because their effective yield in May was the highest for any Treasury investment up to 10 years. On May 31, for example, a typical FRN was yielding about 2.4% while the 10-year Treasury yield had dropped to 2.14%. That means FRNs currently have about a 25 basis-point advantage over a 10-year Treasury.

That's a pretty remarkable example of yield inversion, because the FRN's base interest rate matches the current 13-week Treasury. Here's a chart comparing the 13-week Treasury yield (in red) with the 10-year nominal yield, dating back to January 2015, a year before the Federal Reserve began raising short-term rates:

10 year versus 13-week Treasury (Source: Federal Reserve of St. Louis)

Today's yield inversion makes FRNs look like a highly desirable investment. But let's take a look at FRNs and ask: Is this the right investment for mid 2019?

What is an FRN?

Floating Rate Notes, which have a 2-year term, were introduced by the Treasury in January 2014. The interest rate of an FRN changes, or "floats," until maturity. The rate - paid quarterly - is the sum of two components: an index rate and a spread. Here are the Treasury definitions:

  • Index rate. This rate is tied to the highest-accepted discount rate of the most recent 13-week Treasury bill (currently about 2.31%). The Treasury auctions a 13-week bill every week, so the index rate of an FRN is reset every week.
  • Spread. The spread, currently about 0.14%, is the bonus return added to the 13-week rate. The spread stays the same for the life of an FRN. The spread is determined at the auction where the FRN is first offered.

In 2014, FRNs looked like an awful investment for a small investor. At the time, a 13-week Treasury was yielding 0.040% and the first FRN auction generated a spread of 0.045%, creating an overall current yield of 0.085%. Not even worth considering.

But once the Federal Reserve began raising its Federal Funds Rate (the basis for all short-term interest rates) in late 2015, FRNs became a lot more interesting. The 13-week Treasury, which is the core interest rate of an FRN, follows the Federal Funds Rate very closely, as shown in this graph:

Federal Funds Rate So that's the appeal of an FRN during a time of rising short-term interest rates: It's a 2-year investment that will benefit weekly from rises in the 13-week Treasury yield.

But what if rates start falling?

It's impossible to predict the path of future interest rates with certainty, but the Federal Reserve has openly placed its rate-hiking program on hold, probably for the rest of 2019. And it's getting more likely that the Fed will begin lowering rates this year, as noted in a CNBC report last week:

Markets now expect the Federal Reserve to cut interest rates twice by late January as economic signs continue to weaken and Wall Street stumbles through another rough patch. Futures trading indicated a 63% chance of a September cut and a 62% probability of another easing by late January, according to the CME’s FedWatch tool.

The inverted yield curve, along with a long trend of mild U.S. inflation, gives the Federal Reserve a lot of leeway to lower interest rates. A few months ago, I didn't think that was likely. But now, after trade turmoil sent long-term interest rates plummeting and stock markets swooning, a series of interest rate cuts looks much more likely.

And when the rate-cutting trend begins, it usually goes quickly and deep, as shown in this chart tracking the 13-week Treasury yield back to 1990, with recessionary periods marked in grey:

13-year Treasury So there's the catch: If you purchase a new 2-year FRN in 2019 (the next new-issue auction is July 24), you are making a commitment to a yield that will track a possibly declining interest rate over two years. For that commitment, you will get about a 14-basis-point advantage over a 13-week Treasury bill.

But with the 13-week Treasury, you can bail out any time after waiting no more than three months. In my opinion, the 13-week Treasury remains the preferred investment, because of the flexibility the shorter term offers.

And if you believe that interest rates are likely to start falling, why not look to lock up today's higher yields with a 5-year bank CD paying above 3%? These may not be around much longer.

FRNs versus TIPS

Treasury Inflation-Protected Securities and U.S. Series I Savings Bonds have a special place in portfolio allocation because they 1) are super safe, 2) provide a rate of return that should be close to that of nominal Treasurys of the same term, and 3) provide insurance against unexpected future inflation.

FRNs are also super safe and provide insurance against an unexpected future rise in interest rates.

I can see the logic of combining TIPS (for inflation protection) and FRNs (for interest rate protection) in a portfolio. But the same goal can be achieved, with more flexibility, by combining TIPS with rollovers of 4-week or 13-week Treasurys, along with longer-term bank CDs.

In conclusion

Back in February 2017, when I started rolling over that 13-week Treasury, it was yielding 0.55%. At the end of the last rollover, it was at 2.42%. That strategy achieved its purpose: I rode interest rates higher. But if I had bought a 2-year FRN back in 2017 instead of rolling over the 13-week bill, I would have gained about a 14-basis-point yield advantage.

So, clearly, the FRN was the better investment in February 2017. And today and into the future, an FRN would most likely outperform any federal money market investment, maybe by 15 to 20 basis points. It would also outperform 13-week Treasurys rolled over continuously for 2 years, by about 10 to 15 basis points.

For cash holdings that you know you won't need for 2 years, an FRN makes sense. But if you might need that cash, look to shorter-term alternatives.

What did I do with my accidental payout? It went back into a 13-week Treasury bill, to be auctioned today.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he recommends can purchased through the Treasury or other providers without fees, commissions or carrying charges.