Thursday, February 6, 2014

Treasury Auctions Floating Rate Notes

On January 29, Treasury auctioned its first issue of floating rate notes. According to press reports, market participants and analysts felt the auction went well. After all, total bids (competitive and noncompetitive) amounted to almost $85 billion for an issue size of $15 billion, which is very good coverage.
The spread the Treasury will pay over the 13-week Treasury bill on these two-year notes is 0.045%. This spread is added to the latest 13-week Treasury bill rate determined at auction, meaning that the interest rate on the floating rate notes changes weekly and is paid out quarterly. (For more details, see the final rule for these securities.) With this spread, the floating rate notes are currently yielding about double the current rates on 13-week bills. It is less than the rate on 2-year notes, which are yielding in the neighborhood of 0.3%, and about equal to the one-month Treasury yield curve rate published by the Treasury.

Given that floating rate notes are effectively one-week instruments, I would agree that this auction produced a fair result. Also, in the current low interest rate environment, the floating rate notes are not likely to be a significant factor in either decreasing or increasing Treasury’s interest costs.
As readers of this blog know, I have not viewed the introduction of floating rate notes favorably. (For example, see this post.) One argument for them is that they are a way to extend the maturity of the public debt. The reasons for extending the maturity of the public debt are to lessen rollover risk and to reduce the variability of interest payments. As I noted in the linked post, the Treasury has never had a problem in rolling over bills in modern times, and floating rate notes do nothing to reduce fluctuation of interest payments due to changing market conditions.

I was surprised to see that usually astute Gillian Tett of the Financial Times seems confused on the latter point in an article of hers recently. She wrote:
“…this benefit [of borrowing short-term] comes with a sting that mortgage borrowers know well: if rates increase, interest payments could balloon. And if investors panic about inflation, higher rates or fiscal sustainability, that squeeze could be more intense.
“The good news is that the Treasury is aware of this danger, and trying to prepare. In recent months it has had success in raising the average maturity profile by selling more long-term bonds. This stands at 66.7 months, and officials say that by 2020 it could reach 80.
“Treasury officials are also trying to help the market absorb future rate rises by offering a more flexible range of instruments. This week’s experiment with floaters is one move…”
Another reason to issue floating rate notes is to broaden the appeal of Treasury securities to new investors. I think this argument had some merit in making the case for Treasury issuing inflation-indexed securities, since inflation-indexation made for a different asset class, though I am not certain how significant this has been. With floating rate notes, I am doubtful. These seem to be mainly designed to appeal to existing investors, such as money market mutual funds, for which there is a clear benefit. While Treasury does not have any problems rolling over securities, it is bit of a hassle for investors to have to rollover their maturing securities. Also, in the current climate, possible disruptions to Treasury’s auction schedule when Congress has not passed the debt limit in a timely matter may be of some concern to investors in short-term Treasury securities. Perhaps, money market mutual funds should bid aggressively for floating rate notes, giving Treasury a break in the yield, since there are clear advantages to them from these securities.

Finally, I would like to make one general point. In recent years, there has been instability in Treasury’s debt management strategy. During the Clinton and George W. Bush administrations, there were efforts to shorten the average maturity of the public debt, in addition to the decision by the Clinton Administration to issue inflation-indexed securities, an idea which had been rejected by previous Democratic and Republican administrations. The decision to shorten the average maturity of the public debt was pursued aggressively by the George W. Bush Administration with its decision to eliminate the issuance of 30-year bonds, a decision that was subsequently reversed after the major Treasury proponent of this, Under Secretary Peter Fisher, left Treasury.
The argument for shortening the average maturity of the public debt was that Treasury long-term yields are usually higher than short-term yields and that the Treasury would save money over time and interest rate cycle by issuing more short-term securities. That rationale was rejected by the Obama Administration, which decided to extend the maturity of the public debt during a time of historically low interest rates. The decision to issue floating rate notes does not fit neatly into the lengthening strategy, but it has been portrayed that way.

Of course, it is not the President who is making these decisions but the Treasury Secretary and political appointees at Treasury. While it is hard to ascribe motives, it appears that at least some political appointees wanted to leave their mark on debt management, which is usually, absent a debt limit problem or other crisis, a fairly low profile, though critical, task. In the broad scheme of things, the instability of debt management brought about by different political appointees is probably not that important, but it is not an optimum way to operate.

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