By egstark
June 27, 2014

Bumbling. Bureaucratic. In the wake of bailouts and botched health exchanges, these words are routinely assigned (often unfairly) to those in public service. So when government does something right, let’s give credit where it’s due.

In January the Treasury Department flawlessly launched its first new debt product in 17 years: the two-year floating-rate note, or FRN. Not only did the first auction go smoothly, but bidding interest outstripped supply by nearly six to one and has remained robust.

Low Return, But No Risk

What’s the attraction? First, there is no credit risk with FRNs since the government presumably will never default on its debt. (Fingers crossed.) And there is little interest rate risk, because the rate on FRNs resets or “floats” every week in accordance with the rates set at Treasury’s weekly auction of 13-week bills. In contrast, a fixed- rate note will lose value if rates rise, as happened in 2013.

Yep. Virtually no risk, and the T-bill benchmark is one of integrity, unlike the scandal-plagued Libor to which many private-sector floating notes are tied. Plus, FRNs are easy to buy on the TreasuryDirect website in $100 increments. The downside is that you have to give up yield in ex­change for all that safety. The average yield on FRNs is a paltry 0.09%, or $9 on an investment of $10,000.

One might ask why you would settle for a tenth of 1% when a two-year, fixed-rate Treasury note yields four times as much. Given the Fed’s apparent determination to keep short-term interest rates near zero to infinity, is there really a risk they’ll rise appreciably?

Indeed, rates are likely to stay low. “Likely,” however, isn’t the same as “definitely.” The Fed may be forced to raise rates if inflation returns or Wall Street starts doing really crazy things with all that money the central bank is pumping into the economy. We’re already seeing relaxed lender protections in commercial loans, a proliferation of (over)leveraged buyouts, and junk debt selling at sky-high prices. Feeling a bit of déjà vu?

Good Deal for Taxpayers Too

A more legitimate concern about FRNs is from the taxpayer’s perspective: As interest rates go up, won’t Treasury’s costs rise?

But the government already faces interest rate risk on the short-term bills that it sells, as they must be continually renewed at market rates. Matthew Rutherford, an assistant treasury secretary, explains that by substituting FRNs for part of Treasury’s weekly bill issuance, taxpayers aren’t exposed to any new interest rate risk.

So if that risk is well managed, I give a thumbs up to this government innovation. These continue to be scary times on Main Street. Financial reform remains a work in progress. No one fully understands the consequences of the Fed’s unprecedented monetary interventions. FRNs give risk-averse households a safe harbor until we know we’re safely out of the storm.

Sheila Bair is former chairman of the Federal Deposit Insurance Corp.

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