Must know: Do inflation-indexed bonds make for easier investments? (Part 3 of 4)
The U.S. Treasury’s recent $15 billion auction of the two-year Floating Rate Notes (FRNs) in January 2014, was heavily subscribed. The attractiveness of the FRNs is quite obvious as they offer floating interest rate in a rising-rate environment, where Fixed Coupon notes tend to lose, which makes them less susceptible to interest rate volatility.
Consequently, the first Floating Rate Treasury Bond ETFs, including the iShares Treasury Floating Rate Bond ETF (TFLO), hit the market in February 2014, which tracks the Barclays U.S. Treasury Floating Rate Index, which is also a new index consisting of 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 an investor 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.
A duration of just 0.01 years, means that these bonds are highly protected from interest rate volatility. To learn more about duration, read our series on duration. Usually, duration of floating-rate bonds is seen to be half the time between two consecutive interest payments. For example, for a bond with quarterly interest payouts, duration would be somewhere near 0.125 years (half of one-fourth of a year). However, these bonds have a duration as low as 0.01 years.
The new Treasury FRNs are structured to pose close to no interest rate risk to the investor, as the interest rates will reset daily, based on the last three-month T-bill auction, which reduces its duration to as low as 0.01 years. Read more on the terms of the new Treasury FRNs in the term sheet.
Overall, these new securities should appeal to the investor. With a fixed rate bond, when rates rise, the value of the bond falls because newer bonds pay more. But when interest payments rise along with market rates, the value of the security remains stable. In this case, the rate will adjust with market conditions, and since market conditions are already at near zero, the adjustment can only be a positive one. For investors who buy short-term, high-quality debts like T-bills, FRNs provide a very good alternative.
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