Tuesday, February 14, 2012

Treasury Debt Management and Floating Rate Notes

The U.S. Treasury Department is considering issuing floating rate notes (“FRNs”).  Judging by the 27 pages of “discussion charts” devoted to floating rate notes released on February 1, I would assume that Treasury is strongly leaning to issuing FRNs. (The slides on FRNs come after the Treasury slides.)  It is not clear who prepared these slides, but apparently it was one of the current members of the Treasury Borrowing Advisory Committee (“TBAC”), with no doubt assistance from staff of his or her firm.

Why Treasury is considering issuing FRNs at this time is puzzling.  While financing needs are at record levels, interest rates are at historic lows.  In fact, given market conditions, TBAC recommended in its report to the Secretary that Treasury accept negative yield bids in Treasury bill auctions.  (A negative yield means that the purchaser of a bill is effectively paying the Treasury interest for the privilege of lending money to the Treasury.)  The same report, though, indicates that the TBAC unanimously recommends that Treasury issue FRNs linked to a short-term rate, which would likely be either the three-month bill rate or the Fed Funds rate.  TBAC estimates that the FRN yield would be around 8 basis points higher than the three-month bill rate.  The report states that “FRNs give Treasury an attractive alternative to increase the average maturity of its debt.”
From Treasury’s point of view, this maturity argument makes no sense.  One of the reasons that is typically cited for extending the maturity structure of the public debt is “rollover risk.”  But Treasury never has a problem rolling over T-bills, and from an interest cost perspective, FRNs are a substitute for bills.  Given that Treasury sells bills every week, the marginal operational costs of issuing bills is approximately zero.  In fact, one could argue that the yield on FRNs should be lower than the bill rate, since FRNs eliminate the need for investors to roll over their holdings of short-term instruments.

Another reason cited for extending the maturity structure of the debt is to make interests costs a less volatile outlay of the federal government.  But FRNs, by definition, do not accomplish this goal, and thus they should not be viewed as substitutes for longer-term debt from Treasury’s perspective.
Back in the late 1990s, Treasury considered issuing FRNs, as well as inflation-indexed bonds.  There were disagreements among staff and political appointees on both instruments, but Larry Summers rejected issuing FRNs.  He was intent on issuing inflation-indexed bonds (now known as “TIPS”), as many economists were recommending at the time, and he saw no reason to issue FRNs, either as a substitute for or in addition to TIPS, especially since he was advised that the yield on FRNs would float above the bill rate.