Why You Should Take A Look At Floating Rate Treasury Notes

As interest rates rise, bond portfolios will generally lose value. In response, investors have shifted to cash or cash-like positions, such as short-term Treasuries, while they wait to allocate with more conviction. What many do not know is that the Treasury Bills are still very exposed to movements at the short end of the Treasury curve even though they have maturities and durations of less than one year. In many cases, these positions have lost money in rising rate environments, while those consisting of floating rate Treasury notes (FRN) have not. As the 10-year yield looks to be range bound for the coming year, we believe that short-term rates are likely going to rise, given that the Federal Reserve (Fed) is expected to raise rates two to three times in 2017.1 

What Are Floating Rate Notes?

While it is a relatively new asset class, floating rate Treasury notes have had some proven success during prior rate hike environments, and investors should look to use them as alternatives to traditional short-term Treasuries. FRNs are 2-year notes that reset weekly to the rate of the newly auctioned 13-week bill. Put simply, these bonds have a one-week duration, because any risk of missed opportunity of investing in higher-yielding bonds is mitigated by the weekly rate reset.
Launched in February 2014, FRNs are the first new marketable security issued by the U.S. Treasury since Treasury Inflation-Protected Securities (TIPS) in 1997. While they may be new, the common risks most new bond issuances face are not as relevant here. First, new bond issuances from untrusted issuers can certainly cause doubt in the minds of investors. However, the U.S. Treasury has been issuing debt for hundreds of years and is arguably the safest lender in the world. Second, investors in bond funds are generally wary of smaller issuances as they can create a constraint on the size of the fund, in addition to potential mispricing due to escalating demand. However, total market value of FRNs is currently above $300 billion and will likely increase given the Treasury’s preference toward issuing additional short-term bonds. Due to the supply constraints of bonds to use in money market funds, the Treasury is increasingly favoring FRNs as a way to meet short-term liability needs.