Everything you need to know about floating rate treasury bills

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Investors should expect a new form of public debt. Later this year or early next year, the US Treasury is expected to issue its first new form of security since Inflation-Protected Treasury Notes (TIPS) in 1997: Floating Rate Treasury Bills (FRNs). . On May 1, the Treasury announced its intention to issue two-year FRNs. The interest rate will be linked to a 13-week US Treasury bill auction rate, which is reset weekly.

For investors, FRNs are likely to provide a hedge against rising rates and a rally in yield versus a T-bill. For the Treasury, the FRNs could help reduce the “rollover” ?? risk associated with holding auctions, in particular the risk that an auction does not attract customer interest, and also contributes to diversifying its investor base.

However, since interest rates are reset periodically, FRNs will not allow the Treasury to lock in record funding rates and may even expose it to higher borrowing costs in the future. Is this really advisable at a time when an unprecedented monetary stimulus can lead to higher rates and inflation? A growing majority of institutional investors and Treasury officials believe so.

Why deliver them? The Treasury’s FRN issue sends an important signal to the market: it tells creditors that the Treasury intends to extend the maturity of its debt without sanctioning buyers who choose to go beyond cash equivalents ( or Treasury bills) in a reflationary environment. To explain why the Treasury would do this now, we need to look at how this matches its debt issuance targets.

The Treasury issues debt securities when federal expenditures exceed tax revenues. However, forecasting cash flow requirements can be difficult, and the willingness of domestic and foreign investors to purchase U.S. government debt may vary. This is of particular concern when the United States has a deficit of over $ 640 billion and the Treasury has to issue so many 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 the excessive issuance of short-term debt also increases the risk of refinancing. 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 higher premium for holding US debt, the cost of financing the Treasury could rise rapidly.

Thus, the issuance of FRNs could help minimize the United States’ short-term cash requirements and reduce its refinancing risk by lengthening the maturity profile of the Treasury. Since coupon payments will increase with interest rates, this also assures creditors that extending the maturity profile will not lock them into low interest rates amid higher inflation on the market. road.

How will they be structured? The Treasury has reviewed comments from a wide range of institutional investors, brokers and the Treasury Borrowing Advisory Committee (TBAC) and recently released a draft condition sheet for NRFs.

After heated debate, the TBAC unanimously supported the use of a 13-week Treasury bill issuance rate. The Treasury Bill Index is deep, stable, easy to understand, and has a long history, which makes it attractive to the Treasury. The TBAC noted, however, that this choice of index did not diversify the cost of financing the Treasury. In addition, if FRNs become an important component of future treasury issuance, issuance of treasury bills can be cannibalized. However, at present, the TBAC considers the 13-week Treasury bill rate to be the best choice.

Interest will accrue daily and will be paid quarterly. The rate will reset weekly based on the outcome of the last 13-week Treasury bill auction (June 11, 0.035%) plus a spread, subject to a minimum net yield of zero percent. This minimum is a critical characteristic which should increase the attractiveness of the FRN in the event that the Treasury authorizes the auction of Treasury bills at negative rates.

Although many details have been released, the Treasury has yet to specify the frequency and size of the auctions. The TBAC recommended one open and two subsequent re-openings 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 that individual issues are larger and have greater secondary liquidity. We anticipate that the Treasury will accept TBAC’s advice and issue a more detailed mod sheet next quarter. Finally, we anticipate that Treasury FRNs will initially replace some Treasury bill issues, but could potentially substitute for some fixed rate coupon issues in the future, as the Treasury plans to issue longer term FRNs.

Who will buy them? Investors who expect unconventional monetary policy to lead to higher rates would be encouraged to buy FRNs as a hedge. However, the demand within the channels may differ.

Foreign central banks can be natural buyers of FRNs. They currently hold about 25 percent of the T-bill supply and 40 percent of the T-coupon supply. Rolling holdings of treasury bills is a basic strategy for these risk averse investors. So owning FRNs, which minimize rollover transaction costs, can be attractive.

Investors in corporate cash may also find them attractive. Unlike money market funds, which are limited by a 120-day weighted average maturity (WAM) calculation, FRNs offer corporate liquidity investors a similar duration to treasury bills, but with potentially a return. higher.

Banks may be slow to adopt FRNs as they can currently deposit excess reserves with the Federal Reserve and earn 0.25%. However, they might find FRNs attractive in the future if the rates on these issues exceed the interest paid on excess reserves. Additionally, as regulators continue to pressure banks to increase the credit quality of their portfolios, FRNs can be particularly attractive given the scarcity of high-quality assets.

Total Return (TR) managers, who often manage against a benchmark like the Barclays US Aggregate Index (BAGG), may also have modest demand for this security. FRNs are unlikely to be added to the BAGG index (TIPS is also not included), so TR managers may be slow to adopt. However, some TR managers may purchase FRNs in order to deposit these securities as collateral for centrally cleared derivatives; this could be a growing source of demand for FRN in the years to come.

Finally, the $ 2.5 trillion domestic money market sector currently holds around 30% of its total assets in US Treasuries, which could be a natural source of demand for NRFs in the near term. However, money market managers will need to weigh the benefits of holding an FRN rather than holding a slightly lower yielding, fixed rate Treasury bill. An important consideration for a money market fund manager is to maintain a portfolio with a dollar weighted average life (WAL) of no more than 120 days. Allocating a modest 5 percent of a portfolio to a two-year FRN will add 36.5 days (365 days x 2 x 5 percent) to the WAL ?? bucket. ?? Although most funds subject to rule 2a-7 of the Investment Company Act of 1940 (which sets requirements for the credit quality, maturity and liquidity of investments) currently have a large place in their WAL compartment, as the FRN program grows, their participation may be limited due to the WAL constraint.

Will Pacific Investment Management Co. buy them back? Like any security available for investment, US Treasury FRNs will be subject to rigorous analysis. We will assess the merits of these stocks based on Pimco’s top-down macro view and valuation-driven bottom-up analysis. In addition, we will assess the suitability of these titles based on client goals and account specific guidelines.

Pimco may consider switching from treasury bills to FRNs if the higher yield justifies the extension of the average maturity compared to 13 week treasury bills. In addition, holding a combination of Treasury coupons (notes and bonds), TIPS and FRN can allow us to gain views on nominal forward yields, real yields and inflation without resorting to derivatives. However, before purchasing a Treasury FRN, the short-term bureau will carefully consider secondary market liquidity.

We look forward to the first FRN auction by the Treasury as well as the opportunity to continue adding value for our investors through careful assessment of this and other investment opportunity.

Paul Reisz is Executive Vice President in the Newport Beach office and Product Manager covering the spectrum of money market strategies, enhanced liquidity and income. Mark Romano is Executive Vice President and Account Director in the Newport Beach office, focusing on investment advisory firms, clients and developing new client relationships. David Linton is vice president and portfolio manager in the Newport Beach office, specializing in financing and money market operations.

The authors would like to thank Jerome Schneider and Steve Rodosky for their contributions to this article.


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