Why do investors continue to prefer floating-rate notes?

Market Realist

Must-know: Why the Treasury yield curve declined last week (Part 7 of 7)

(Continued from Part 6)

Floating-rate notes

Floating-rate notes (or FRNs) offer investors a chance to gain yield when interest rates rise—and with short-term interest rates very low at the time of the introduction, they offer investors a low-risk, high-quality alternative to Treasury bills, eliminating the rollover costs associated with Treasury bills.

FRNs are a security that has an interest payment pegged to a benchmark rate. As the benchmark interest rates rise, the security’s interest payments increase. Similarly, as interest rates fall, the security’s interest payments decrease. The FRN is the first addition to the Treasury’s offerings since inflation protected notes were introduced in 1997.

Advantages of FRNs

  • For the Treasury, these notes help attract new investors and help limit its short-term cash needs by acting as a funding substitute to T-bills.
  • Limits rollover risk—the Treasury depends on bill holders to roll over their holdings with each new bill issue in search of better yield.

Two-year FRN auction results

Last week’s Treasury auctions included $13 billion two-year Treasury FRNs auctioned on May 28. The FRNs were indexed to the May 19 13-week Treasury bill auction high rate, which is the highest accepted discount rate in a Treasury bill auction.

Though the offering amount was reduced from $15 billion in April to $13 billion for the May 28 auction, two-year FRNs saw an increase in demand in the past week, as reflected in the increase in bid-to-cover ratio. The bid-to cover ratio for the FRNs auctioned on May 28 rose to 4.69x from a 4.64x ratio in April.

Buy-and-hold investors (direct and indirect bidders) stepped up against primary dealers, which could take only 48% of the $13 billion offering—the lowest dealer share in the near history of the two-year FRN auction.

Investors’ takeaway

Pursuant to the launch of two-year Treasury FRNs in January 2014, iShares launched its first floating-rate Treasury bond ETF, the iShares Treasury Floating Rate Bond ETF (TFLO), in February 2014. TFLO tracks the Barclays U.S. Treasury Floating Rate Index the first-issued Treasury FRNs. With an average maturity of 1.96 years and a duration as low as 0.01 years, the TFLO provides investors with maximum protection in a rising rate environment, as the ETF’s price would take a hit of just 0.01% for every 1% rise in interest rates.

In February, WisdomTree also launched its WisdomTree Bloomberg Floating Rate Treasury Fund (USFR) to track U.S Treasury FRNs.

For investors willing to take on greater risk for greater return, the iShares Floating Rate Bond ETF (FLOT) is a good option. FLOT tracks the performance of U.S. dollar-denominated investment-grade floating-rate notes issued by companies including the likes of Goldman Sachs (GS) and JP Morgan Chase (JPM).

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