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. Treasury 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 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 have an incentive 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 Treasurys 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 Treasurys maturity profile. Since the coupon payments will rise along with interest rates, it also assures creditors that extending the maturity profile wont 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, 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 Treasurys 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 be paid quarterly. The rate will reset each week according to the result of the most recent 13-week T-bill auction (0.035 percent as of June 11) 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.
Although 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 reopenings 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 TBACs 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.