Why investors should look at floating rate notes as an option (Part 5 of 7)
Fulfilling investor needs
The U.S. Treasury Department’s latest issue on January 29, the floating rate note (or FRN) will fulfill two investor needs: participating in anticipated future interest rates increases and protecting principal against default, as the notes are backed by the full faith and credit of the U.S. government. Now the question arises, why can’t the investor do this using the Treasury’s existing debt instruments—like 30-year Treasury bonds, for instance?
This is because interest rate risks associated with longer-term bonds are much higher compared to shorter-term bonds—in this case, 30 years compared to two years. Bond prices increase as interest rates fall and decrease when interest rates increase. Effective duration (measured in years) measures the sensitivity of a debt security’s price to a 1% parallel shift in the yield curve. For example, a bond with a duration of 15 years will see its price drop 15% for every 1% increase in interest rates.
Generally, a higher bond duration implies that the investor will have to wait longer for the payment of coupons and principal at maturity, so this translates into a price fall as interest rates rise. The converse is also true. When interest rates decrease, the higher the duration, the greater the security’s price increase.
The duration for FRNs issued by the Treasury will be the same as the duration of a three-month par bond since the notes will be re-priced every three months. Compare this to the 30-year Treasury bond, whose duration will be much higher due to its longer maturity. Since markets anticipate a period of rising rates, interest rate risk impact on 30-year Treasury bonds will be much higher as the FRNs despite having a maturity of two years have an effective duration of only three months, which reduces the price fall arising from adverse interest rate movements.
How do loans compare to FRNs? Continue to Part 6 of this series to find out.
Browse this series on Market Realist: