Almost two decades after advising the U.S. to sell floating-rate notes to lower debt expenses, Campbell Harvey says starting to issue the securities now would be a costly mistake for American taxpayers.
“In an environment with historically low interest rates, the Treasury should avoid floating-rate debt as it introduces risk,” Harvey, a finance professor at Duke University’s Fuqua School of Business in Durham, North Carolina, said in a telephone interview April 17. “If interest rates go up, it puts the government at risk because they will need to come up with a lot of extra revenue to pay the interest bill.”
The U.S. may detail plans for floaters on May 2 when it discloses quarterly funding needs, Mary Miller, the Treasury Department’s undersecretary for domestic finance said in a Feb. 1 press briefing. The Treasury Borrowing Advisory Committee, the bond dealers and investors who meet quarterly with the agency, unanimously endorsed them in February, more than 19 years after Harvey told a Congressional committee that bonds with rates set periodically based on a short-term benchmark would reduce costs.
Floaters would increase the link between the government’s interest payments and movements in short-term rates, which have been near zero since 2008. The Treasury has sought to lock in borrowing costs for longer and cut the amount of outstanding short-term bills, which ballooned to $2.1 trillion during the financial crisis that began almost five years ago.
While the administration of President Barack Obama forecasts the budget deficit will exceed $1 trillion for the fourth year, interest expense was 3 percent of the economy in fiscal 2011 compared with 4.1 percent in 1999, when the U.S. ran budget surpluses.
Floating-rate notes, which would be the first new U.S. government debt securities since Treasury Inflation-Protected Securities were introduced in 1997, may increase the supply of the safest short-term investments in the face of record demand by money market funds and investors.
The securities may appeal to investors wary that four years of Federal Reserve monetary stimulus will spark inflation and cause the central bank to lift short-term rates even though policy makers have promised to keep borrowing costs near zero through 2014.
The floaters will probably have a maturity of one- to three-years initially, according to Bank of America Corp. The coupon would reset periodically based on a short-term benchmark, such as the federal funds effective rate, or the Depository Trust & Clearing Corp.’s Treasury overnight repurchase agreement index. Payments to investors would be similar to those of U.S. Treasury bills, while also increasing along with rates.
Spending programs to pull the economy out of the worst financial crisis since the Great Depression more than doubled the amount of marketable securities outstanding to $10.34 trillion from $4.34 trillion in mid-2007.
Treasury bills, securities due in a year or less, peaked at more than $2 trillion outstanding in August 2009 amid government spending on bailouts, which started under the George W. Bush administration in 2008 and continued under Obama. The programs include the $700 billion Troubled Asset Relief Program and investments in mortgage finance companies Fannie Mae and Freddie Mac. At the end of last year, the total had fallen to $1.52 trillion, still 46 percent higher than the average of $1.04 trillion since 1996.
The benchmark 10-year note yield was little changed at 1.92 percent at 3:42 p.m. New York time, compared to 3.43 percent a year ago. Three-month Treasury bill rates were 0.09 percent, while the six-month bill rate was 0.14 percent.
“The Treasury is interested in limiting their reliance on bills and having to roll over so much in short-term debt,” said Alex Roever, JPMorgan Chase & Co.’s head of short-term fixed-income strategy in New York during a telephone interview on April 23. Floaters “could become sort of a bill substitute while continuing to give the Treasury access to lower rates in the front-end,” he said.
A decision may be announced in two days, when the department details sales of notes and bonds, an official who briefed reporters on condition of not being named said on Feb. 1. They are also considering allowing negative yields at Treasury bill auctions, as recommended by TBAC.
The Treasury lowered its net borrowing estimate for the current quarter today, reflecting lower government spending and higher issuances of state and local government securities. The estimate for April through June was revised to $182 billion, $19 billion less than projected in January. U.S. officials also see net borrowing of $265 billion in the quarter starting July 1.
There’s plenty of precedent for floaters from corporate bonds. About $123 billion, or 12 percent, of the $1.01 trillion company bonds issued in 2011 paid variable interest, according to the Securities Industry & Financial Markets Association. Government agencies including Fannie Mae and Freddie Mac also sell them.
A Barclays Capital index of U.S. floating-rate debt with maturities of two- to three-years is up 2.8 percent this year. Bank of America Merrill Lynch‘s U.S. Corporate and Government Master Index has gained 1.4 percent in the same period.
The supply of inflation-linked notes, or TIPS, has surged since the government began offering them 15 years ago to lower U.S. borrowing expenses and allow retirement savings to keep pace with inflation. There were $769 billion of outstanding notes at the end of March, according to Treasury data. TIPS returned 14.1 percent last year, compared to 9.8 percent for Treasuries that weren’t indexed to consumer prices, Bank of America Merrill Lynch indexes show.
Harvey, 53, recommended during House Ways and Means Committee hearings on President Bill Clinton’s Plan for Public Investment and Deficit Reduction proposed in 1993 that the Treasury supplement its bond offerings with adjustable-coupon debt to help reduce interest costs in the years ahead. At the time, Treasury 10-year notes yielded about 6 percent and the Fed’s target rate for overnight loans between banks was 3 percent.
The University of Chicago-trained economist, who has taught at Duke since 1986, is also a research associate at the National Bureau of Economic Research, the body which determines when recessions begin and end.
If the Treasury had converted half its outstanding debt in 1993 into floating-rate notes or bonds, the interest expense savings would have amounted to about $2 trillion given the fall in rates since, according to estimates by Harvey.
Yields on 10-year notes fell to a record 1.67 percent in September. The government can still lock in near-record low longer-term rates with fixed coupons. The Fed has kept its target rate at an all-time low range of zero to 0.25 percent since 2008.
“Longer-term debt is pretty expensive right now for investors, with long-term yields so low, so the Treasury would probably pay less in the long run by issuing longer-term debt rather than floaters,” said Bruce Tuckman, director of financial markets research at the Center for Financial Stability in New York in an interview on April 18.
“There is an enormous global demand for super-safe, short-term assets,” Tuckman said. “Floaters are quite safe in terms of interest-rate risk. But, relative to short-term debt, floaters are a bet on long-term U.S. credit, which could damp their appeal to investors who place a great premium on safety.”
Demand is increasing amid regulatory requirements that banks hold safer assets and investors flee Europe’s financial turmoil. Money has plowed into Treasuries at a record pace.
Investors bid $4.50 for every dollar of four-week Treasury bills offered at auction in the first quarter, compared to a bid-to-cover ratio of 2.7 during the first quarter of 2007.
“This might be an opportunity to issue debt with a fixed term but with a floating rate that might answer some of the demand we see in the market for high quality short-term-like instruments,” Treasury’s Miller said Feb. 1. We believe “there will be some benefit to our interest expense. It may also help us reach our objective of fixing out the term of our debt,” she said, referring to the Treasury’s goal of extending the average maturity of their debt holdings.
Treasury Secretary Timothy F. Geithner has pushed the average maturity of U.S. debt to 62.8 months from 49.4 months during the financial crisis in first quarter of 2009, to lock in relatively low rates by selling more long-term securities.
Matthew Anderson, a spokesman for the Treasury in Washington, declined to comment April 27 beyond what the Treasury Department has already publicly said regarding the potential floating-rate note program.
Money Market Appeal
“The Treasury can, with floaters, lock in debt at a short-term rate without having to come back in the market as often as they have to do for bills,” said Priya Misra, head of U.S. rates strategy at Bank of America in New York, in an April 10 interview. Rising rates “are a risk to the Treasury relative to them issuing long-term coupon bonds, but not relative to them issuing Treasury bills,” she said.
Misra favors initial monthly auctions of about $10 billion in floaters, which may displace some bills. The Treasury sells bills with maturities of four, 13, 26 and 52 weeks.
Floaters will appeal to the $2.6 trillion U.S. money market mutual fund industry, TBAC said in a Feb. 1 presentation to the Treasury. Boston-based Fidelity Investments, the largest manager of money-market mutual funds, and Federated Investors Inc., of Pittsburgh, the third-biggest, supported the new debt during a public comment period that ended earlier this month.
“An appropriately structured Treasury floating-rate note program would be attractive for our money market funds,” said Kevin Gaffney, a fund manager at Fidelity, which has $1.5 trillion under management, including $437 billion in money markets as of Dec. 31, in a telephone interview on April 24. “The debt would also provide an incremental yield pick-up over Treasury bills.”
Fidelity recommended Treasury use the shortest possible period to reset the securities’ interest rate, and a final maturity of one to two years for the floaters. That would enable money funds to be “significant purchasers” and meet government liquidity requirements, according to their public comment.
While Fed policy makers say their benchmark rate will remain “exceptionally low” at least through late 2014, a pick-up in the U.S. recovery could trigger an earlier rise. This is the risk Duke’s Harvey and others say didn’t exist in the higher-rate environment of 1993.
“I don’t get why the Treasury thinks floaters are a good idea with short-term rates at zero percent, as they only have one way to go, and that’s up,” said James Bianco, president of Bianco Research LLC in Chicago in an interview on April 24.
“They should be lessening the cost of financing the United States government for the taxpayers,” Bianco said. “The Treasury should be issuing 100 year or perpetual bonds until the market can’t stand it anymore to lock in these rates.”