Before the Great Recession, adjustable-rate mortgages (ARMs) allowed many borrowers to cross the line. Now the US Treasury has decided to take out what is equivalent to an ARM of its own by introducing floating rate notes.
As the name suggests, floating rate notes have variable interest rates, which adjust up or down periodically. Interest rates are linked to an index, such as Libor, which provides a benchmark for changes in interest rates. In May of this year, the Treasury postponed its decision to issue the notes because, among other things, Treasury officials could not agree on which index to use. They have not yet reached a consensus on an index or the final maturity of the securities, but their decision to issue the notes still suggests important information about the state of mind of the Treasury.
The US government is betting that the historically low interest rates on Treasury debt will stick around for some time. The wisdom of investors in recent years has been to “borrow long and lend short,” either by refinancing your mortgages at near-historically low interest rates or by avoiding long-term fixed-income securities, which can generate a substantial amount of interest rate risk.
The United States government is now doing the exact opposite. Treasury officials seem content to finance long-term government obligations with short-term loans. Although the average maturity of outstanding US government debt has lengthened, it remains one of the lowest of any developed country, at just over 5 years. By contrast, the average maturity of outstanding UK debt is more than 14 years.
Instead of taking advantage of the historically low interest rates offered by the Federal Reserve and the demand for US Treasury debt caused by the European crisis, the US government has taken the most politically expedient path. The government knows that it can borrow almost nothing by issuing short-term securities. As of September 4, 2012, the government could borrow for a period of one month at a rate of 0.10 percent and up to one year at 0.16 percent. For comparison, a 10-year Treasury note had a rate of 1.59 percent and a 30-year bond had a rate of 2.69 percent.
Most people would jump at the chance to borrow money at less than 3 percent for 30 years. That rate is still below the long-term average for inflation, about 3 percent. In real terms, the government is likely to get away with borrowing at such low rates, even over the long term, because inflation will likely outpace the interest cost of the debt. This means that the government will pay lenders with dollars that are less valuable than when they were slow.
However, when you run a $1 trillion budget deficit, it’s in your best interest to keep your borrowing costs as low as possible, regardless of inflation. With an outstanding federal debt of more than $16 trillion, fractions of a percentage translate into billions of dollars. Keeping interest rates as low as possible may make things easier for the government in the short term, but it is ultimately short-sighted.
Many have urged the government to issue more 10-year notes and 30-year bonds to maintain current low rates. There have even been calls for the US to issue 50 or 100 year bonds. In the past, the Treasury doubted there was enough demand to support long-term debt issuance. However, the demand for 100-year bonds is evident. Even Mexico was able to issue 100-year bonds in 2011 with a yield of less than 6 percent, and earlier this year the University of Pennsylvania issued 100-year bonds with a record low yield. Since then, interest rates in the US have continued to decline.
However, according to the most recent data provided by the Treasury, the government has only issued a total of $270 billion in 10- and 30-year debt in the first seven months of 2012. It takes less than a month for the Treasury to issue that debt. . amount in short-term bills, which are instruments that mature in six months or less.
As a US citizen, you must ask yourself why the government is not taking advantage of the opportunity created by this low interest rate environment and instead decided to issue debt that will raise your borrowing costs if future interest rates rise.
To be fair, given the amount of short-term financing the government uses, your borrowing costs will rise even without the introduction of floating-rate notes. The government must constantly hold auctions to renew its debt obligations; in these auctions, public debt rates are adjusted to what the market will bear.
It could be argued that floating rate notes could even help the government if they reduce the number of Treasury bills issued. Floating-rate notes could cause investors to lock up their money for longer periods of time, which would reduce the number of Treasury auctions. Reducing the number of auctions would in turn reduce the likelihood of a failed auction should US creditworthiness deteriorate, a prospect that even an economy as strong as Germany’s has faced in recent months. The Treasury may be sending a signal, through the decision to issue floating-rate notes, that it is concerned about the prospects of such a failed auction.
Now put on your investor hat. You may be wondering if these securities are appropriate investments, regardless of what it means to the government. Despite my reservations about the issuance of floating rate notes and the long-term outlook for the country’s debt, I believe they may offer benefits to investors, given the current interest rate environment. Variable rate notes provide a hedge against rising interest rates, because their coupons adjust as rates rise. This reduces the interest rate risk of the securities.
Some investors may find that they prefer floating rate notes issued by the US Treasury because these notes will be backed by the US government. However, investors will likely lose higher returns from this reduction in risk. For investors looking for a place to invest cash for short periods, Treasury bills will likely remain the best option, as investors will avoid holding onto their money for a long period of time.
The first addition to the US Treasury lineup in more than 15 years seems like a great bet. Just as many homeowners bet that they could trade in their homes before the interest rates on their ARMs expired, the US government is betting that it can ride the wave of low interest rates for a while longer. This approach may serve to cover up the country’s financial situation in the short term, but we have to hope that the government doesn’t wipe out and end up under water like the hapless owners.