The Treasury announced last week it will hold its first-ever auction of Floating Rate-Notes (FRNs) on Thursday, Jan. 29. This is the first new Treasury product in 17 years, following the launch of Treasury Inflation-Protected Securities in 1997.
I’ve already noted that these FRNs look like a bad deal for small investors, and are actually designed for the large-scale holdings of hedge funds, money-market funds, pension funds and foreign governments, where they could lower volatility of short-term investments.
Here is info from that previous post to fill in some basic facts on FRNs:
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 yield on a 13-week Treasury is a whopping 0.04% and that is down ‘substantially’ from 0.07% on Jan. 2, 2014. Obviously, no one gets rich investing in 13-week Treasurys.
But the new FRNs are expected to get a yield premium over a 13-week Treasury. How much of a premium? That’s the key question. The current 2-year Treasury yield is 0.37% so we know the premium won’t be more than 33 basis points. It will probably be a lot less, as noted in this Wall Street Journal story from Jan. 23:
Pricing of the new notes will be based off a yield spread over the rate on three-month Treasury bills, so as the bill yield rises, so will the rate on the two-year floater.
Some bond analysts expect the notes to offer about eight to nine basis points in extra yield. At the current 0.035% rate on three-month bills, that means an all-in yield of about 0.11% to 0.12%.
Investors will get a higher yield over time if the rate on a 13-week Treasury rises, but that doesn’t look likely in 2014 or 2015, based on the Federal Reserve’s commitment to keep short-term rates near zero.
The Wall Street Journal speculates there could be strong demand for these FRNs (which would lower the yield even more if bidding is strong):
The new notes also come at a time the Treasury has been scaling back supply of shorter-dated debt, given reduced cash needs with a lower government deficit. That has meant a group of investors fighting for a shrinking pool of Treasurys.
“Pricing will be determined by the combination of limited supply and strong investor demand, given the opportunity to maintain Treasury exposure but earn a spread over bills,” said the rate strategists at Bank of America Merrill Lynch.
The new notes are expected to be particularly attractive to conservative money-market funds, where money must be invested in high-quality and shorter-term securities.
Even if you are interested in these FRNs, there is no need to jump aboard in this first auction. The Treasury will auction FRNs each month, with original issues in January, April, July, and October, and reopenings in the other months.
Or … just buy the TIPS maturing in January 2016 and you’ll get a yield of -1.34%, plus inflation. Not great, but if inflation averages 2% over the next 2 years, you’d get 0.66%, about 29 basis points higher than a 2-year Treasury.