Robust Demand Continues for Floating Rate Treasury Debt

After first issuing $15 billion in two-year floating rate Treasury notes (floaters) on January 29, 2014, the United States Treasury has continued to see strong demand in each subsequent $13 billion reopening. In the current market environment, money market investors continue to be strong adopters of floating rate securities backed by the full faith and credit of the U.S. government. In an update to the evolution of this market, the Treasury auctioned its second new issue on April 29, 2014. Now, with two floating rate securities outstanding, I thought investors would be interested to hear what I believe will be next for the market and why it may make sense for certain investors to increase allocations to this new sector of the fixed income market. Market Cap and Demand Growing Nicely When the newly issued security settled on April 30, the market capitalization for floating rate Treasuries had grown to more than $56 billion outstanding in four months¹. While this amount represents only a small fraction of U.S. government debt, the $750 billion market for Treasury Inflation-Protected Securities had only $15 billion of debt outstanding after the first four months of issuance. That said, I continue to believe that floaters represent an important way for the Treasury to increase the overall maturity profile of its debt, while addressing the drop in money market issuance and investor concerns about rising short-term interest rates in the U.S. For these reasons, WisdomTree was one of the first exchange-traded fund (ETF) sponsors to launch a product, USFR, that invests exclusively in these securities. Although asset levels (and yields) remain low, I believe these securities could make a great deal of sense in investor portfolios once interest rates begin to rise. Grading the Most Recent Auction At the April 29 auction, the $15 billion in freshly offered securities drew in bids that were 4.64 times the amount up for auction². Put another way, the Treasury received bids for approximately $69.6 billion in securities for a $15 billion supply. This bid-to-cover ratio of 4.64x approached similar interest for the Treasury bill auction on the same day and was much higher than the ratios seen for recent Treasury auctions of fixed-rate coupon bonds. While completely adequate, the Treasury has seen the bid-to-cover ratio of only 2.95x for the $701 billion in fixed coupon debt issued so far in 2014. If I were to assign a letter grade to the most recent floating rate Treasury auction, it would be a “B” because of the strong investor interest implied by the bid-to-cover. Talking briefly about the freshly issued security’s characteristics, the high-discount margin at the auction was 0.069%. This implies that for the life of this two-year note, this security will be priced based on this margin above the most recently auctioned three-month Treasury bill. By way of review, we discussed briefly the mechanics of these securities in a previous blog post. U.S. Floating Rate Treasury Note Catalysts for Investment In my view, floating rate Treasuries make sense in the current market environment for investors looking for a cash-like alternative with very little interest rate risk and virtually zero credit risk. Given that short-term interest rates are at all-time lows and the Federal Reserve (Fed) has stated that it could be at least a year before it begins hiking rates, it may not make sense for investors to devote a large portion of their portfolios to these securities. However, this will not always be the case. I believe that once the market has fully digested tapering and starts to focus on the timing of the first round of interest rate hikes by the Fed, the value of these securities will begin to show their worth compared to money market securities and other longer-term fixed income securities. Given the weekly reset, the floaters should adjust more quickly than Treasury bills and will likely be spared the potential losses experienced by two-year Treasury notes as the market adjusts to future hikes in the federal funds rate. ¹Source: U.S. Department of the Treasury ²Source: Bloomberg