US Treasury May Issue Debt With Floating Interest Rate

The Treasury Department and its perennial effort to fund the government's steepening debt load may get another weapon in its arsenal.

Treasury Building

Dealers and traders have been approached recently with plans to issue a floating-rate note that for investors would provide an opportunity to profit should rates go up and for the government a chance to restructure its debt even further.

The move comes as Washington recently closed out its fiscal year with a budget deficit of just a shade under $1.3 trillion and a national debt rapidly approaching $15 trillion.

With no end in sight to the debt-and-deficit picture, Treasury is looking at ways to keep borrowing costs down while also bringing investors to the table still willing to lend their money to the US despite all its fiscal challenges.

"The government is trying to find a lot of different avenues to generate revenues here," says Kim Rupert, managing director of global fixed income analysis for Action Economics in San Francisco. "Obviously we have just a plethora of Treasury auctions. Given the budget outlook, it doesn't look like we're going to make inroads on the deficit anytime soon."

With the European Union battling its own debt crisis, investors have continued to buy Treasurys as a safe haven.

Rates have remained low as the Treasury and Federal Reserve has struck an accommodative relationship, with the central bank buying trillions in government debt as a way to stimulate the economy.

The US already has sustained one debt downgrade and may face another before the year is outunless Congress comes up with a debt reduction package suitable to ratings agencies.

Still, bond experts think a floating-rate offering, which would be pegged to the federal funds rate—currently near zero—would still find a market, though probably not among mom-and-pop investors already facing low or no returns on cash and fixed income.

The issuance could come in $20 billion blocks of three-year floating notes, according to a Financial Times report Monday.

A Treasury official said the idea is on their agenda, but declined further comment.

"This is something that's going to fit the extremely defensive bucket of investors' portfolios, or be a key instrument for investors who are invested conservatively," says Robert Tipp, chief market strategist at Prudential Fixed Income in Newark, N.J., a firm with just under $300 billion in assets under management. "Floating-rate securities are likely to meet a number of objectives from the buyer community as well as from the Treasury issuance perspective."

The Fed has been trying to extend the duration of its portfolioin part to drive long-term rates lower and in part to cushion against the risk of having to continually roll over its holdings on the central bank's $2.84 trillion balance sheet.

Institutional investors also would be drawn toward the floating-rate notes as they, too, would welcome not having to roll over their Treasury bills so often, Tipp says.

"Judging from the strong buyer base that exists for short-term Treasurys, a substitute — another investment in that realm — would be well-received," he says. "If investors that like the return profile of bills are able to get a small incremental increase in return and not need to roll them over so frequently, it may prove convenient."

To be sure, there is concern, particularly on trading floors, that the benefit primarily would go to Treasury, while investors would face credit and inflation risks.

"Japan could have done this 15 years in a row. (Investors) will bet that (the rate is) going to rise and it never does," says Kevin Ferry, president of Cronus Futures Management in Chicago. "In a perfect world they would issue 50-year securities and 20-year securities and steepen the curve between 10s and 20s. Buy they don't do that because they don't want to (harm) the Fed."

Getting a Deal on Euro Debt

Ratings agencies also might take a dim view of the Treasury betting on interest rate stability, Ferry adds.

"This wouldn't make Moody's or S&P feeling any more comfortable putting out floating-rate debt when everything is at zero," he says.

And there's also the precarious state of the US fiscal situation, and the fear that loose monetary policy and debt uncertainty would trigger inflation that the return of the floating-rate notes would not be able to keep pace with.

Real inflation rates and cost of living continue to rise, putting in jeopardy any US-backed fixed income investment, says Michael Pento, senior analyst at Agora Financial and president of Pento Portfolio Strategies.

"America just a very short time away from facing reality, and reality is going to be interest rates that rise due to overwhelming supply and inflation," he says. "People have forgotten about the debt debate (in the US) but it's coming back to the fore very quickly."