Why investors should look at floating rate notes as an option

Why investors should look at floating rate notes as an option

The floating rate note

On January 29, 2014, the U.S. Treasury Department issued a new class of security: the floating rate note (or FRN). The inaugural $15 billion FRN issue maturing in January 2016 will pay a floating rate interest rate based on an index of three-month Treasury bills (T-Bills). This is the first new security introduced by the Treasury since 1997, when the Treasury launched inflation-protected securities or TIPS.

Part 1 - Yield CurveEnlarge Graph

What are floating rate notes (FRNs)?

A floating rate note is a debt security with a variable interest payment. The interest rate usually references an interest rate benchmark, such as Libor or the three-month Treasury yield. As interest rates rise, the security’s interest payments are expected to increase, so its yield increases. Conversely, FRN interest payments decrease as interest rates fall.

The auction process for FRNs, the minimum and maximum purchase and award amounts, and the award methodology will be the same as for other Treasury securities, and quarterly interest payments will be scheduled.

The two-year FRN issue is expected to provide protection to investors against a rising interest rate environment. A security like the FRN that’s linked to a shorter-term security like the T-Bill will pay current interest rates. Markets have long been anticipating rising rates as the U.S. Federal Reserve gradually ceases its open market purchases of agency-backed mortgage-backed securities and longer-term Treasuries. This will enable investors to benefit from rising rates on the short end of the curve—that is, short-term interest rates.

FRNs provide options to investors who have flocked to leveraged loan ETFs like BKLN in search of higher yields. HJ Heinz, which was recently taken over by Berkshire Hathaway (BRK-B), is the largest issuer in the leveraged loan index that BKLN uses, with a yield of 3.25%.

In addition to benefits to investors, FRNs will allow the Treasury to better manage its debt by issuing securities with slightly longer maturities than Treasury bills and a marginally higher cost of borrowing.

For more on why investors should look at FRNs as an investment option, move on to Part 2 of this series.

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