Research Brief

A ‘Safer’ Treasury Bond

The government’s floating rate notes feature an added measure of security: higher interest earnings in times of rising rates

U.S. Treasury bonds are widely considered the safest securities on Earth — at least, if your measure of “safety” is whether you’re assured of getting back every penny of your principal, plus interest. But there’s a newer kind of Treasury issue that is even more iron-clad, making it worth a look by income-oriented individual investors.

The Treasury introduced two-year floating rate notes, or FRNs, in 2014. Unlike conventional Treasury securities, which pay a fixed interest rate until their maturity date, FRNs pay interest that adjusts to reflect changes in short-term market rates. The adjustment happens every week for the notes’ two-year terms. In times of rising rates, that feature removes from FRNs the biggest risk that Treasury bond buyers face: the danger of getting locked into a low rate while newly issued bonds are paying more.

Research by Matthias Fleckenstein of the University of Delaware and UCLA Anderson’s Francis A. Longstaff shows how valuable that floating-rate feature can be for investors: They found that the market prices of FRNs have fluctuated very little from their maturity value (or “par” value) of $100 per bond. “The volatility of the market price over the entire life of an FRN issue is typically only about two to six cents per $100 par amount,” the authors write in a National Bureau of Economic Research working paper.

Graphic: Monika Brown

That makes FRNs “among the most-stable collateral or store-of-value options available in financial markets,” Fleckenstein and Longstaff write. In other words, even though the notes don’t mature for two years, investors consider them virtually as good as cash at any moment.

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By contrast, say you own a conventional fixed-rate two-year Treasury note. If you have to sell it before it matures, and market interest rates on new two-year notes are sharply higher than the yield on your note, a buyer would pay a discounted price from the $100 par value to reflect your note’s below-market yield. The amount of the discount would depend on the difference in yields, but it could easily be measured in dollars rather than pennies.

The ABCs of FRNs

Here’s a primer on how the Treasury’s floating rate notes work:

  • New notes are sold (technically, “auctioned”) by the Treasury once a month. Individual investors can buy them direct from the Treasury, free of fees, by opening a TreasuryDirect account online at TreasuryDirect.gov.
  • FRNs are sold in increments of $100. To buy at a monthly sale, individuals enter “non-competitive” orders, which means they agree to accept the average yield at the sale. Interest is paid to your account quarterly.
  • The notes have two-year terms. Each week during that term, the interest rate you earn is reset, based on yields at the Treasury’s weekly auction of 13-week T-bills. The T-bill yield closely tracks the Federal Reserve’s benchmark short-term rate, known as the federal funds rate. The FRN rate is the new T-bill yield plus a “spread” set by the Treasury on each FRN issue at auction. As of the seven days beginning March 5 the annualized yield on the most recently issued FRN was 2.424 percent plus a spread of 0.115 percent, for a total yield of almost 2.54 percent.
  • Treasury interest is subject to federal income tax but is exempt from state and local income taxes — a bonus for investors in high-tax states.
  • Each FRN issue matures two years from its issue date. On the maturity date an FRN owner would be refunded the note’s full “par” or face value ($100 per note).

Of course, the floating-rate feature of FRNs means that your interest earnings would decline in a period of falling short-term rates. But for now there is no sign of that on the horizon. The Federal Reserve has been raising its key short-term rate for the last two years as the economy has improved. The most recent increase, in December, lifted the Fed’s benchmark rate to a range of 2.25 percent to 2.5 percent. The Fed now suggests it won’t raise rates further in 2019, though that will depend on the economy’s strength. If the Fed holds steady so should the short-term Treasury rates.

An investor with perfect timing would hold FRNs until longer-term fixed-rate bond yields peaked, then sell the FRNs and buy the fixed-rate bonds to lock in those peak yields. But perfect timing eludes most professional investors, let alone amateurs. Longer-term Treasury bond yields have already declined from their 2018 highs. For example, the 10-year Treasury note yield peaked at 3.26 percent last October, the highest since 2011. It was 2.69 percent as of March 6. On the same day, the most recently issued FRN was yielding just 0.15-point less, at almost 2.54 percent. What happens next to short-term rates depends mostly on the Fed, while the direction of longer-term rates — up or down — depends on many more variables, including the economy’s health, inflation, the dollar’s value and geopolitics. It’s a crapshoot.

In any case, Fleckenstein and Longstaff’s research shows that investors are so enamored of FRNs that they have often bid aggressively to buy them when the Treasury has auctioned new issues each month. In market parlance, investors pay a “stability premium” for FRNs, the authors write. So the notes save Uncle Sam (and taxpayers) money compared with the Treasury’s issuing conventional bonds in their place. So far, the Treasury has issued more than $900 billion in FRNs. Fleckenstein and Longstaff estimate the government has saved nearly $1 billion in interest costs with FRNs.

“In theory, the potential savings from refunding all fixed-rate Treasury debt with floating rate debt could be orders of magnitude larger,” the authors write.

Featured Faculty

  • Francis Longstaff

    Distinguished Professor of Finance, Allstate Chair in Insurance and Finance, Area Chair

About the Research

Fleckenstein, M., & Longstaff, F. (2018). Floating rate money? The stability premium in Treasury floating rate notes.

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