With interest rates at historic lows, investors are looking to floating rate bond funds as a way to help protect portfolio value as interest rates rise. The proof is in the numbers: investors allocated $9.2 billion to floating rate ETFs in 2013, including $3.1 billion into the iShares Floating Rate Note ETF (FLOT).
Luckily for investors, a new type of floating rate security just hit the market. On January 29th the U.S. Treasury issued $15 billion of its first floating rate Treasury bond. It’s the first time the U.S. Treasury has issued a new security type since 1997, when they introduced Treasury Inflation Protected Securities (TIPS). These new floating rate notes are designed to pay more interest to the bondholder if short term Treasury yields rise.
Each new floating rate Treasury bond will have a final maturity of 2 years at issuance. The coupon rate paid will be a spread over the most recent 13-week Treasury bill auction rate, and will be re-set each week. For example, when Treasury Floating Rate Notes were first issued, the spread was set at 0.045%. The yield on the Treasury bill index was 0.055%.
This means that for the first week of issuance, the bond will pay an interest rate of 0.10% annualized. When 13-week Treasury bills are auctioned again the following week, the coupon rate will reset to 0.045% plus the new auction rate. Interest rates on floating rate Treasuries rise and fall as the T-bill rate increases or decreases.
The chart below shows the history of the 13-week T-bill rate versus the Federal Funds Target rate. As you can see, the T-bill rate moves along with changes in the Fed Funds rate. As we don’t expect the Fed to raise the Fed Funds rate in the near term, it is likely that T-bill rates will also remain low. When economic activity picks up and the Fed begins to raise rates, that is when we would expect the coupon rate on Treasury Floaters to rise.