A few readers have asked about the new Floating Rate Notes (FRNs) that the Treasury began issuing last month and how they work.
In short, they’re Treasury bonds with a 2-year maturity and with an interest rate that adjusts over time (as opposed to most bonds, which have fixed interest rates). Specifically, the interest rate on Treasury Floating Rate Notes is calculated as:
- The rate on the most recent issue of 13-week Treasury bills (which will change every week, since new bills are issued every week), plus
- A spread that is determined (via auction) when the Floating Rate Note is issued (and which does not change over the life of the FRN).
For example, the first issue of FRNs has a spread of 0.045%. To this we add the rate on the most recent issue of 13-week Treasury bills (0.041%), to get a current interest rate of 0.086%.
As you can see, these new debt instruments have a very low yield. And there’s a reason for that: They’re very low-risk — less risky, even, than typical 2-year Treasury bonds.
Interest Rate Risk (i.e., Price Fluctuation)
With most bonds, the reason that their market value fluctuates over time is to make the bonds competitive (i.e., desirable to buy or sell) relative to new issues. For example, if you own a Treasury bond that you purchased in a period of lower interest rates, nobody would buy it from you unless you sold it at a discount (i.e., the value of the bond has gone down because rates have gone up). Conversely, if you have a bond that you purchased in a period of higher rates, the only way somebody could convince you to sell it would be to offer you a premium (i.e., the value of the bond has gone up because rates have gone down).
Floating Rate Notes, however, have an interest rate that adjusts along with market interest rates. As a result, their price does not need to fluctuate as much in order to keep them competitive with new issues. In other words, they will experience less price volatility than regular 2-year Treasury bonds. (And regular 2-year Treasury bonds already experience only a modest degree of price volatility due to their short duration.)
Treasury Floating Rate Notes are nominal bonds. That is, unlike TIPS or I-Bonds, they do not have a built-in inflation adjustment, so they are exposed to some inflation risk. That said, their exposure to inflation risk is about as low as you can get for nominal (i.e., non-inflation-adjusted) bonds.
When it comes to nominal bonds, owners of short-term bonds are less exposed to inflation risk than owners of long-term bonds. That’s because, in periods of significant inflation, interest rates will tend to increase. And the sooner your bonds mature, the sooner you’ll be able to reinvest your money at those higher rates.
FRNs are even safer than regular short-term bonds in this regard though, because in the event that inflation and interest rates spike upward, you don’t even have to wait for your FRN to mature take advantage of the higher rates. Instead, your Floating Rate Note’s interest rate will adjust every week when new 13-week Treasury Bills are issued.
In summary, the new Treasury Floating Rate Notes are quite low-risk in terms of default risk, price volatility, and inflation risk. And they have the super-low yields that you would expect from such a low-risk investment.