Felix Salmon

Why would Treasury want to issue floaters?

By Felix Salmon
August 3, 2012

Treasury announced yesterday that it was going to start issuing floating-rate notes, probably at some point next year, although the details are still extremely vague:

Treasury projects that it must now sell an estimated $667 billion of additional debt to the public over the next four years. The floating-rate notes will help give the government flexibility in its increased debt offerings…

Officials confirmed that the notes will not be indexed to the Libor overnight lending rate, which has come under scrutiny in the wake of a scandal that it was manipulated during the financial crisis.

The Borrowing Advisory panel said it was interested in referencing the securities to the DTCC GCF Repo index.

None of this makes a huge amount of sense to me. For one thing, if you’re the US Treasury, with $16 trillion of debt outstanding, an increase of half a trillion over four years is not a really huge deal — especially in a world where demand for Treasury securities remains incredibly robust.

What’s more, a floating-rate note isn’t really a new product. At heart, it’s incredibly similar to an investment in T-bills; the only real difference is that you don’t need as many roll-overs with a floating-rate note.

And then there’s the question of the reference rate. Don’t be embarrassed if you haven’t heard of the GCF Repo index: it’s less than two years old, and it has been tradable for only a couple of weeks.

The Repo index gives an overnight interest rate from the repo markets, and as Stephen Stanley of Pierpoint Securities points out (via Pedro da Costa), there are serious risks there.

Continuing in the mode of offering self-serving advice that would be bad for Treasury, the TBAC recommended that Treasury use the new GCF index as the reference rate for FRNs. This would put Treasury in a position of taking on private credit risk, since, if we had a 2008-style meltdown and general collateral (rates) widened out due to counterparty risk, Treasury’s FRN borrowing costs would soar.

Good luck to any Treasury Secretary who would have to explain that to the House Oversight Committee. That sounds like a one-way ticket to a forced resignation.

Essentially, repo rates always include a certain amount of counterparty risk, and they can spike alarmingly during a credit crisis when no one trusts anybody any more, and there’s a huge flight-to-safety trade going on. It would be utterly bonkers, in that situation, for the yield on floating-rate Treasury securities to go up, rather than down.

But even if the reference rate was Fed funds, or some other interest rate which doesn’t include counterparty risk, there are still problems here: I don’t think it should be an overnight rate at all. The way that floating-rate notes work, they pay an interest payment every coupon period, which is calculated by looking at some reference rate. The interest payments can come every quarter, or twice a year, and the reference rate, similarly, is usually a three-month rate, or maybe a one-month or six-month or one-year rate. The period between coupon payments is generally pretty close, on the yield curve, to the duration of the reference rate.

But the Treasury floaters, by contrast, seem to anticipate using an overnight rate to calculate the periodic interest payment. And that’s very dangerous, because overnight rates are by their nature more volatile and unpredictable than rates for 30 or 60 or 90 days. During crises, it’s quite common to see yield curves which are very steeply inverted between overnight and 30 days: the overnight rate could be in triple digits while the three-month rate could be in the teens. One of the tools in every central bank’s arsenal is the ability to ratchet up overnight interest rates in order to crack down on speculative activity; again, there’s absolutely no reason why that kind of action should result in higher interest payments on government debt.

Finally, it seems a little bit weird for Treasury rates to be linked to themselves, which is the other obvious alternative: using the three-month Treasury yield, say, as the reference rate for a longer-dated Treasury FRN would set up all manner of odd arbitrage trades with no real underlying value.

If a country is borrowing in someone else’s currency, then I can absolutely see why floating-rate notes can make a lot of sense for both issuers and investors. But the U.S. borrowing in its own currency? I really don’t see it. It might well provide some nice profit opportunities to the dealers who sit on Sifma’s Treasury Borrowing Advisory Committee. But I’m far from convinced that Treasury should listen to them.


12 comments so far | RSS Comments RSS

3m OIS rate would be ideal. It’s driven off the overnight Fed Funds, yet gives you a 3m equivalent. It does not spike in a liquidity crisis.

By the way there would be huge demand for FRTs. Institutional guys who want some rate protection would eat it up.

Posted by SoberLook.com | Report as abusive

“Why would Treasury want to issue floaters?”

Maybe it has something to do with the fact that the big rabbis on The Street instructed them to do so. Think?

Posted by MrRFox | Report as abusive

You raise interesting points, particularly in regards to the counterparty risk embedded in the rate and some of the other reasons why the rate could be much higher during periods of financial stress. However, if this is true, floating rate treasuries would have a great return profile and would act as the perfect hedge for investors against tail risk. This is worth a lot, and the market would recognize it. If this notes were issued and the effects you speculate about could be corroborated by data, it is very likely that the spreads vs. the reference rate would be significantly negative. In fact, it is very possible that this could be a new avenue for the government to borrow at negative interest rates. A treasury secretary would surely have an easier time explaining it to congress if this is the case.

Posted by Squarecircle314 | Report as abusive

@Sq314 – indeed, it’s all about interest-rate tail-risk. Holders of long Treasuries stand to get creamed if rates rise. Passing the tail-risk on to the issuer, the Treasury, covers this – and puts all that risk on the taxpayers (where The Street thinks all risk belongs).

I believe it was FS who wrote about GS advocating this idea, a few weeks back. The Street loves it. Doesn’t that make you feel good?

Posted by MrRFox | Report as abusive

If Treasury needs to borrow (and I think we all agree that it does), then why isn’t it taking advantage of today’s ultra low borrowing costs and selling longer term bonds?

There’s forty year mortgages out there in the wild, Geithner should get with the program and issue 40 year fixed interest rate treasury bonds.

Posted by Strych09 | Report as abusive

Sounds like another round of welfare for the bankers. Rates are incredibly low now. A rational actor would be locking them in for 30 years, or even better, issue Consuls with no redemption date. This is obviously Geithner and his buddies stealing a bit more from the government.

Posted by Kaleberg | Report as abusive

Borrowing long & fixed makes tons of sense right now – except on the ethical front. As it stands, all long Treasuries are interest-only, balloon payment at maturity – when most all of us will be dead, and our grandchildren will have to cover the principal.

Would be OK if we were spending the debt$ to create assets that could serve following generations, like Hoover Dam continues to serve us. No dice – we want consumption, our consumption. If we’re going to borrow long, we at least ought to do it ‘fully amortized’, and discharge some of the principal before we check out.

Posted by MrRFox | Report as abusive

I have thought about floating-rate issued by the treasury, but I had imagined linking it to the results of six-month auctions, and had imagined them as a retail product. The primary savings bond, up to 10 years or so ago, had a floating-rate component linked in a strange way to the five year Treasury; I had thought, though, that letting Grandma take some cash and putting it in six month bills without having to go roll it over until she needed the liquidity would be useful for both Grandma and the fed.

Posted by dWj | Report as abusive

I agree with the point made above that the Treasury should be lengthening average maturities now, with long-term rates so low.

There is some conceivable value to the Treasury of issuing FRN’s, for a couple reasons. One would be if it attracts a class of buyer who would prefer these to other Treasury bonds or notes. I’m sure it’s a number north of zero, but I’m dubious it’s a large group. Another is if it allows the Treasury to borrow at a rate similar to short-term bills, but without the need to rollover the debt every 3 or 6 months. So, that said, I’d say give it a try on a limited basis, but first work out the objections that Felix has raised regarding the details, which seem valid to me.

Posted by realist50 | Report as abusive

Don’t neglect the asset/liability mismatch aspect, as well. The Feds guarantee/hold God knows how many trillion$ in fixed-rate mortgage 30s. Borrowing fixed for 30 effectively hedges that exposure in way that borrowing floating-rate doesn’t.

Posted by MrRFox | Report as abusive


Floaters would expand the market for goverment debt. Lots of investors won’t accept a return which is effictively controled by inflation. The goverment has every incentive to support inflation to minimize the cost of outstanding debt. Floaters will partially offset that risk to investors who will be willing to lend to the treasury longterm at ultra low short term rates. For a year or more you could have 20 year floating rate debt at like 50 basis points.

You’re absoutly right about consults as well. Now would be the time to issue those… it would be worth haveing a few trillion out there that the treasury would never have to worry about refinancing. Investors have different goals and prefrences, your right that Consols would be gobbled up by investors as well.

Posted by y2kurtus | Report as abusive

@Y2Kurt – either you or me, not sure which, but one of us has missed Kaleberg’s point. Selling fixed-rate rate Consols now makes good sense – buying them is nuts. Would investors “gobble up” these fixed-rate turkeys? I don’t think Kaleberg expresses a view on that.

Posted by MrRFox | Report as abusive

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