Expectations of future shortages in quality liquid bonds in US debt markets continue to persist (see story). These shortages however are likely to be more acute for short-term paper. As a percentage of total government debt for example, treasury bills …
In January the US Treasury will auction off the first set ($10-15bn) of floating rate notes (FRNs). These are two-year notes with quarterly payments based on the 3-month treasury bill rate plus (or minus) some small spread. The notes will be auctioned off at par, with the premium/discount built into the spread (see term sheet below). It has been some 17 years since the US Treasury has introduced a new product. The demand for “floaters” has been strong as fixed income investors grapple with rising rates. The rally in senior leveraged loans for example (see post) has been driven to a large extent by the fact that the coupon on these products rises as rates increase. And now the Treasury will attempt to take advantage of this demand.
The 3-month treasury bill rate is currently around 7bp vs. the 2-year note yielding about 34bp. So why would someone accept such a low rate on a 2-year product when they can lock in a higher rate with a fixed rate note? The reason is that the market expects the 3-month bill rate to rise quite sharply in the next couple of years. Therefore while the expectation is that the FRN buyer will make much less at the beginning, at some point the coupon will rise above the current 2-year note rate to compensate investors for the lower initial yield. Ultimately (in an “arbitrage-free” world), the expected effective yield on a 2-year FRN and a 2-year fixed-rate note issued by the US Treasury should be roughly the same.
Who will buy these products? The biggest demand will come from money market investors – those who currently buy bills. Because the FRNs are equivalent to “rolling” a three-month bill, rated money market mutual funds now have permission from the rating agencies to buy the notes. S&P released a statement recently saying that the “new U.S. Treasury Floating-Rate Notes are consistent with our principal stability fund ratings criteria”.
There is some concern however that this FRN program will reduce the amount of treasury bills available in the market, particularly as the Treasury attempts to lengthen the average maturity of total debt outstanding.
JPMorgan: – Going forward, we expect Treasury to err on the side of caution, and our forecast assumes $10bn in monthly FRN issuance until the program is more developed. Furthermore, our issuance forecast shows FRNs as a substitute for Treasury bill issuance, consistent with the goal of lengthening the weighted-average maturity (WAM) of the Treasury debt.
As discussed back in July (see post), treasury bills as a percentage of total government debt have been on a decline for some time, and the new FRNs are expected to further reduce this supply.
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In recent years the 1-month treasury bill has been quite sensitive to policy risks. While in the past the bill mostly responded to changes in the Fed’s overnight target rate, in the current zero rate environment other events cause bill pricing to fluct…
Yields on treasury bills with near-term maturities have spiked to multi-year highs as the debt ceiling deadline approaches. While market participants are generally expecting to see a resolution (albeit a temporary one), some are not taking any chances.
USA Today (AP): — Fidelity Investments, the nation’s largest money market mutual fund manager, has sold all of its short-term U.S. government debt — the latest sign that investors are increasingly nervous about the possibility of a government default.
|Source: US Treasury|
Institutional investors have rolled a chunk of their holdings into cash during September but in the last week or so started pulling out of government money market funds – moving funds into bank deposits instead.
Investors fear that their accounts will be frozen, as money fund managers who don’t receive timely payments on bills are unable to meet redemptions. Many money market funds also use repo (collateralized loans) with treasuries or agency MBS as collateral. These short-term loans usually yield slightly more than treasury bills, giving money markets a few extra basis points. But with bills under pressure and investors getting out, repo rates have suddenly risen as well.
Bloomberg: – “We’ve seen some rise in repo rates in sympathy with the broad move higher in money-market yields, most dramatically in the near-term Treasury bills, given concerns over the debt-ceiling,” said Andrew Hollenhorst, fixed-income strategist at Citigroup Inc. in New York. “October futures contracts have had a sharp yield rise, signaling expectations for significant moves higher ahead, consistent with the sharp spike we saw in 2011 before the August debt-limit deadline.”
Some continue to believe that a technical default by the US government would impact treasury securities only. But as we see from the repo example, that assumption is quite naive. An adjustment to bill rates is already rippling through a number of other money market instruments. If we don’t have a resolution on the debt ceiling soon, the shock will ripple across broader markets as well.
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