The Wall Street Journal reported that the U.S. treasury introduced new type of bonds into treasury bond markets. This new type of bond is a floating rate bond also known as FRN. This FRN provides different interest rates structures to investors. Its maturity is two years, and its interest rates payments depend on short term three-month treasury bill and the spread. The FRN pays out interest rates of three-month treasury bill plus the spread, which is the augmented interest rates on three-month treasury bill. For example, the spread of the FRN is 0.045%, and this week three-month treasury bill is 0.035%. Then, total interest rates of FRN is the sum of the spread and three month treasury bill interest rates, 0.08%.
This characteristic of FRN provides investors an opportunity to reduce potential capital loss, which can result from the increase of market interest rates. As the U.S. economy recovers from the Great Recession, there is a growing concern of the Fed increasing the federal funds rates. Early this year market experienced turbulence due to the Fed decision to taper its bond buying program. Once the Fed shows any signal to raise the federal funds rates in the future, market interest rates will increase rapidly. This increase of interest rates can be disastrous for the bond holders. As interest rates increases, the price of bond decreases.
In this situation, the FRN seems to be a reasonable investment tool for investors, especially for those who seek for short term safe investment opportunities. If the three-month interest rates increases to 0.050% from 0.045% in the coming weeks, then total interest rate of the FRN will increase to 0.085%. So, investors of the FRN will get capital loss from the increase of interest rates, but the interest rates of the FRN will increase too along with the increase of the three-month treasury bill, this increase of interest rates payment will compensate part of the capital loss of the bond.
This FRN also is good strategy for the U.S. treasury. As the economy recovers, the demand for long term bonds decreases. The U.S. treasury should pay more interest rates for issuing bonds to revolve maturing bonds. This worsens the burden of the revolving the current debt. But, with this FRN, whose interest rates are much lower than ordinary vanilla bond, the U.S. treasury can limit the increase of interest rates payments burden. In the meantime, for the long term investors, whose main strategy is to buy and hold, vanilla bond is much better investment option than FRN. Two-year treasury bill still pays $40 for $10,000 while two year FRN pays only $8 for $10,000.