Preview: The New Treasury Floating-Rate Note

floating-rate investment incomeFor bond investors who are  interested in variable-rate investments that increase interest payments as general interest rates rise, things should be getting a lot more interesting in the next few months.  The U.S. Treasury is scheduled to announce this month (November) the size of its initial January 2014 offering of new Floating-Rate Notes (FRNs). 

Overview

According to the Federal Register, the Treasury will be able to issue FRNs with maturities between one year and ten years.  The interest rate on these notes would effectively reset weekly based on the results from the weekly auction of 13-week Treasury bills.  The actual interest rates would be equal to the 13-week T-bill rate plus some “spread” amount.  Interest would accrue daily and be payable quarterly.  The Treasury is expected to issue no more than four FRNs per year.

Initial Offering

The initial January offering is expected to consist of $10-$15 billion of notes with 2-year maturities.  One of the key advantages of these notes is that they will have a minimum net yield of 0%.  This means that even if the Treasury allows T-bill auctions to result in negative interest rates, these notes will never be priced to reflect negative interest rates.  Individuals may purchase these notes through Treasury Direct with a $100 minimum. 

Outlook

I am expecting these notes to be very popular, especially if interest rates drift higher.  Banks (including foreign central banks) and corporate cash investors will be the dominant buyers, but individuals seeking a safe alternative to commercial floating-rate notes will also be buying.  Holding these notes will be a popular alternative to rolling T-bills, which may incur significant transaction costs.  The high demand for these notes will likely lead to relatively low yields (probably just slightly higher than the T-bills).  Like other safe, but lower-yielding products, these notes will be excellent vehicles in which to park cash or to use to ensure preservation of capital in a rising-rate environment.  Unfortunately, at least initially, the rates will still be too low to be attractive to most income investors.  When interest rates are a little higher, and the Treasury offers longer maturity floating-rate securities, those will most certainly be smart investments for income.

Are Floating-Rate Funds Too Risky?

floating-rate fundsFloating-rate funds provide higher yield income to investors by buying bank loans made to companies with low credit quality. I like to think of these bank notes as intermediate-term junk securities (loan maturities are about seven years). Yields are higher because of the greater credit risk, but the banks consider the risk of loss somewhat limited because they have priority over other bondholders in the event of default. The securities are “floating-rate” because the bank loans are variable-rate loans. Since fund yields rise as interest rates rise, many investors see these floating-rate funds as attractive income investments that can hedge against inflation.

But are there other risks that investors should be aware of? In July 2011, the Financial Industry Regulatory Authority (FINRA) issued an investor alert warning on floating-rate funds. Here are some things you need to be aware of if you are considering investing in these funds:

– Bank loans are traded over the counter, not on an exchange. Thus, they are less liquid than investment grade bonds, and determining appropriate valuations for individual loans is difficult.

– Many floating-rate funds limit your ability to withdraw your money. Minimum holding periods and redemption fees are common.

– Many floating-rate funds have high expense ratios.

– Some floating-rate funds are leveraged (i.e., they borrow money to purchase additional loans to get higher returns). For these funds, the consequences of loan defaults could be more severe since the cost of buying on margin has to be factored in.

In one of his articles (here), Larry Swedroe makes the case that floating-rate funds really have equity-like risks and behave more like stocks than Treasury bonds.

At the present time, I don’t like these funds for all of the reasons given above, and because it is still likely that low interest rates may persist for a while longer (remember that in August 2011 Bernanke promised low interest rates through mid-2013). In the future, after an inflation trend has been established, I may take another look at them, but right now, I still see significant downside risk to owning these funds. In my book, they are not smart investments for income.