US government bonds no longer have to be fixed income

Bonds, which are debt securities, are often known as “fixed income” investments. This is mostly correct but not strictly accurate. A typical bond pays a fixed coupon, which is an amount of money normally paid twice a year, for a set number of years after which the bond principal is repaid.

But it is possible to issue a debt security with a variable rate of interest.

The US government started doing that in January of 2014 when it issued a floating rate note or FRN. In US terminology a note is mid-way in maturity between a bill (up to a year) and a bond (more than two years). So the T-bond is for more than two years in maturity while a Treasury note is for two years. But generically a fixed maturity debt security is known as a bond. The new FRN has the same two year maturity as existing Treasury notes but is new in that the coupon payment is set according to the discount rate on13 week Treasury bills.

FRNs are already common in the US debt market, where the biggest issuers are the government sponsored entities (GSEs) Fannie Mae and Freddie Mac. These organisations have a lot of interest rate sensitive income and therefore can issue interest rate sensitive debt. They have traditionally been seen as very close in credit quality to the federal government because of a perceived government guarantee on their debt. There never was an actual legal guarantee but the perception turned out to be correct when both were, in effect, bailed out and nationalised (technically they went into “conservatorship”) by the US government during the financial crisis in 2008.

In Europe FRNs are issued by and bought by banks, which use them to fine tune their balance sheets and manage interest rate risk.

Who buys FRNs?

Why issue such a security? If there is an investor demand for a debt security then the US government may be able to cut its overall debt service cost by creating a supply. There are good reasons to think there is a market for FRNs. Suppose you want a zero credit risk security that pays some sort of return but you fear that interest rates will rise. A Treasury FRN gives you protection because if short term interest rates rise, as reflected in the discount rates on T-bills, then the coupon you receive on your FRN also rises. Clearly if interest rates fell then you would have been better off buying a conventional fixed interest rate two year note but at current historically very low interest rates that’s very unlikely.

The financial markets allow you to swap fixed for floating debt so in theory you can always create exactly the type of debt security you want but there are transactions costs involved. So buying a ready made FRN from the US Treasury is appealing.

The first auction of FRNs on 29 January 2014 raised $15 billion. Not much compared with the $12,496,778,978,755.21 of debt held by the public (that is, excluding government debt held by various trust funds – see this blogpost for explanation). It’s touching that the US government’s Treasury Direct website records the daily debt outstanding to the penny.

The Federal Reserve Bank of New York’s ever helpful Liberty Street blog gives more information on the new FRN. It turns out that it’s not the first sovereign floating rate note; Italy and Japan have both issued them in the past but not currently. The blog examines why the Treasury decided to use the T-bill discount rate as the reference, when some people argued for the repo rate, a private sector measure of short term interest rates. And it reveals that the buyers of the new FRN were broadly similar in type to the buyers of conventional two year notes: dealers and brokers, banks and foreign investors.

In summary the US government issues:

  • T-Bills – up to one year, discount securities (they don’t pay a coupon, but are issued at a discount to the face value at which they are redeemed, the discount providing a de facto rate of interest)
  • T-Notes – one to two year securities, which pay a coupon, either fixed or floating
  • T-Bonds – securities with maturities beyond two years, paying a fixed coupon.

Note that it is possible to issue a perpetual debt security, meaning one that never repays the principal. The UK government has some securities of this type, known as consols (short for consolidated annuities), and first issued in 1751. It might seem odd for an investor to buy a security which never repays the principal but that is no problem if it’s traded in a liquid market, since you can always recover the amount you invested by selling the security to somebody else. That buyer in turn depends on selling to another and so on, in an infinite chain. Only if you thought that in future the bond might not be attractive to another buyer would you hesitate to buy it now. So perpetual bonds can only credibly be issued by very secure borrowers such as the UK government.

UPDATE

The New York Fed published additional information on the investors in this new market in January 2015 here.

One Response to US government bonds no longer have to be fixed income

  1. Discounting the Fed’s “bid”, bid/cover ratios for treasury auctions are in <2 territory. They have failed. The floating rate issue serves as a signal- policy rates will remain low for a long time. The "fixed income" 7-10 yr treasuries will outperform equities into next year.

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