The persistent fear over rising rates drives demand for investments that protect from interest rate risk. Now you can add Treasury floating rate notes (FRNs) to that growing list.
At the start of 2014, the Treasury auctioned its first floating rate notes. Since then FRN ETFs started popping up as another way to own these notes. But should you? Are there better options available?
How Does It Work?
The Treasury floating rate notes are a 2-year maturity government bond (with all the same guarantees) with the addition of an adjustable interest rate.
These work like any other floating rate bond. There are two pieces to the interest rate: a fixed rate and an adjustable or floating rate.
The floating rate is tied to the rate on the 13-week Treasury bill which is set every week. You add to that the fixed rate, known as the spread, which is set at the time of the auction.
Say you bought some February 2014 Treasury floating rate notes. To find the current interest rate on those notes, you need the spread at the time of the auction and the most recent 13-week Treasury bill rates. You can find all this information at TreasuryDirect.gov, where you buy these floating rate notes.
The spread at the February auction (circled in the image above) was set at 0.045%. You add to that the most recent 13-week Treasury rate (circled in the image below) of 0.041%, to get an interest rate of 0.086%. It’s not much but you’re buying these to protect from short-term interest rate spikes, not income.
Treasury bills, are already low risk, because it’s guaranteed by the government. Adding a floating rate, lowers that risk further compared to the typical fixed rate Treasury bill.
This is because bond prices move opposite of interest rates. With a fixed rate Treasury bond, rising rates push the bond price down. But with a floating rate note, the interest rate is adjusted higher, leaving the price of the bond the same.
FRNs vs. TIPs
How are FRNs different from TIPS? The table below breaks it down:
|Maturity||2 years||5, 10, 30 years|
|Interest Payments||Every 3 months||Every 6 months|
|Risk Protection||Rising interest rates||Inflation|
Both of these bonds are built for capital preservation but do it in different ways. TIPS protect from inflation (protect your purchasing power), which is one piece of the interest rate puzzle. Interest rates can rise without rising inflation, but the opposite won’t happen.
If you’re debating between FRNs or TIPS, consider the maturity. FRNs are a short-term solution to interest rate spikes. TIPS are built for medium to long-term inflation protection.
For anyone considering floating rate notes, what’s you’re objective with your money? Protection from higher rates? Or to grow your money?
If your goal is preservation and protection, don’t be surprised to find other options that offer the same risk protection with better returns. The best place to look is with similar “safer” short-term investments. Both high yield savings accounts and rising rate CDs offer better rates with the same guarantee on your money (up to the FDIC limits).
If your goal is accumulation and growth, there are better options than Treasury floating rate notes and ETFs with the same name. You give up a lot of potential income for a short-term safety net.