Such a Deal...
by P.J. DiNuzzo February 2, 2014
Such a Deal...
When you think of U.S. government bonds, the word "creativity" isn't always the first word that springs to mind. Yes, the government created inflation-indexed securities back in 1997 for investors who wanted to get a guaranteed returns above the constantly-tinkered-with (and probably not indicative of actual rising costs) Consumer Price Index. But that was 17 years ago.
On Wednesday, the U.S. government will offer people what they've been asking for: a government-guaranteed bond that will give them floating interest rates. "Floating" means that the two-year security's interest rate will reset every day, based on movements in short-term interest rates. This addresses the prevalent fear that interest rates are going to go up sharply, causing bond values to crash and everybody invested in them to lose their shirts. If interest rates go up, the new Treasury security will pay higher interest, and the value will remain constant. Of course, if they go down, which is always possible, then the security will pay lower interest--but, once again, the value will be the same.
These "floaters," as bond traders are calling them, will offer the same return, each day, as the daily return that an investor in three-month T-bills would have gotten on an annualized basis during the most recent Treasury auction. Essentially, that means that people who buy a 2-year floater will get a yield comparable to what bonds with much shorter maturities are paying their investors. This is not normally considered to be a great deal. Currently, 3-month Treasuries are offering a 0.07% annualized rate, compared with 0.39% for bonds with 2-year maturities. Plus, of course, you get the guarantee that if rates go up, so will the rate on your bond.
Is the guarantee worth the rate tradeoff? It may be helpful to know that the U.S. government essentially controls its own bond rates, since the Federal Reserve is still the biggest bidder in the government auctions, and since the Fed also sets short-term rates in the marketplace when it declares the rates at the reserve window where banks can borrow and park their cash. The government doesn't have a great incentive to cause Treasury rates to rise dramatically--and, therefore, raise its own borrowing costs--just like you wouldn't voluntarily let companies charge more interest on your credit card debt. You should also know that as economies become healthy and robust--which is one goal of all these Fed QE interventions we keep reading about--the yield curve typically steepens, which means interest rates rise for 10-30 year bonds, but not so much (if at all) for short-term maturities.
Add this up, and you have a formula where the economy might recover gradually, and the Fed might lose a bit of control over the longer-maturity rates, which would rise and potentially hurt investors holding longer-term government bonds. Meanwhile, shorter-term rates might rise little if at all, giving the government a chance to borrow from floater investors for two years and pay them 3-month rates.
As an extreme example, imagine if short-term rates were to double and 3-month T-bonds were to start paying 0.14%. You would still be much better off owning 2-year bonds paying 0.39%. In fact, you would be better off owning (and holding to maturity) 2-year bonds if short-term rates were to go up 500%, to 0.35% a year.
WILL short-term rates go up more than 500% over the next two years? Nobody knows for certain, of course, but the only people currently talking about such a dramatic rise are those who are also investing in canned food, shotguns and cabins far away from the apocalypse they expect to rage through our countryside. The government seems to have learned an interesting lesson from Wall Street: when people are fearful, sell them safety at a very high markup.
P.J. DiNuzzo, CPA, PFS®, AIF®, MSTx, MBA
President, Founder, and Chief Investment Officer