Why investors can benefit from floating rate notes, or FRNs

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Tapering

In both December and January, the U.S. Federal Reserve announced it was reducing open market purchases of agency-backed mortgage-backed securities and longer-term Treasuries by $10 billion per month. Currently, the U.S. Fed purchases $65 billion per month in OMP, which is expected to reduce over the course of 2014. With the commencement of the Fed’s tapering of its quantitative easing program, money supply is expected to tighten and interest rates should increase. FRNs represent an effective way for investors to benefit from the anticipated rising interest rate environment and also provide a safer place to park cash than fixed interest bonds while the current market turmoil clears up. 

Enthusiastic response from investors

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The inaugural $15 billion FRN issuance on January 29 was priced at a premium of 0.045% over an index of 13-week Treasury Bill (T-bill) rates offering 0.055%, and it was very well received by investors. The bid-to-cover ratio stood at 5.67, meaning the issue was oversubscribed over five times. Investors sought to benefit from anticipated rising interests due to the beginning of Fed tapering.

However, the option to benefit from higher future interest rates comes at a cost. On January 28 (the day before the FRNs were auctioned), the Treasury sold $32 billion in two-year fixed-rate debt at a yield of 0.38%, the highest since August, and higher than the FRNs.

While other floating-rate debt instruments are available, the high quality and low risk profile FRNs represent make a compelling argument for investors looking to benefit from future interest rate movements as well as safety. Current outstanding floating rate debt issues are estimated at $300 billion. Notable floating rate issuers include government-backed mortgage companies Fannie Mae (FNMA) and Freddie Mac (FMCC).

One of the key consequences of the new FRNs is that T-Bill issuance will likely fall. Read on to Part 3 of this series to find out more.

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