By Jason Zweig | 8:15 pm ET Apr. 18, 2014
Image Credit: Christophe Vorlet
Investors who want steady income are used to scrounging around trying to squeeze a little more cash flow out of their securities. Now Uncle Sam is coming to their aid.
In January, the U.S. Treasury began issuing floating-rate notes or FRNs, the first major innovation in U.S. debt since inflation-protected securities were introduced in 1997.
This new investment isn’t a bonanza, but it should enable some investors to earn a little more on their cash. “It’s not quite a free lunch,” says Todd Petzel, chief investment officer at Offit Capital, an investment-advisory firm in New York. “But maybe it’s like a free appetizer.”
The FRNs have a two-year maturity. The interest rate on an FRN consists of two parts: one that floats and one that doesn’t. The floating rate moves in lock step with the most recent three-month Treasury bill, resetting weekly as the government auctions the T-bills every Monday. The fixed rate is a “spread,” or smidgen of extra income above that on the T-bill, that is determined when the FRN is first sold. The spread stays constant until the FRN matures.
This past Monday, the three-month T-bill priced at a 0.035% yield. The FRNs, carrying a spread of 0.045%, thus yielded a total of 0.08%.
FRNs, which you can buy free of brokerage costs at TreasuryDirect.gov, offer a rare opportunity. While you are assured of getting back 100 cents on your dollar two years from now, the interest rate you earn can change every week. Your money is safe for up to two years, but locked up for only seven days—until the floating rate resets.
Therefore, you face almost no risk of being hurt if interest rates rise, as you would be in conventional Treasurys.
“Imagine I buy a three-month T-bill today and then the Fed raises short-term rates next week,” Mr. Petzel says. “Then I’m going to feel like a dummy for the next 12 weeks,” since the rate on the conventional T-bill is fixed. But with an FRN, he says, “you get paid a little extra to wait and you don’t have to wait nearly as long.” The next Monday, your rate will float to the latest market level.
Mind you, you won’t get rich this way. Assuming rates stay constant, if you invest $10,000 in a three-month T-bill and reinvest the proceeds, you will earn $3.50 over the next year. Invest $10,000 in an FRN and you will earn $8. Put $10,000 in a two-year Treasury and you will get about $40.
But getting rich isn’t the point. The goal of owning such short-term investments is to keep your money as safe as possible while pocketing a little income at the same time. Mr. Petzel has one wealthy client with a multimillion-dollar cash balance who, he says, is likely to move some of it into FRNs in the coming weeks. “For savers who want ultimate safety,” he says, “even earning a handful of [extra yield] is a help.”
On the other hand, if interest rates take a sudden jump, the FRNs will begin paying higher yields. Meanwhile, the rate on the conventional two-year Treasury note will remain fixed, although its price will drop. Even though the conventional note offers the higher starting yield, you still could come out ahead buying and holding the FRN instead, if rising interest rates eventually push the FRN’s yield above that of the conventional note. (Falling or constant rates, however, will definitely leave the FRN holder behind.)
“If the Fed raises rates quickly or significantly before maturity, there’s definitely value there” in the FRN, says Vikram Rai, a fixed-income strategist at Citigroup in New York.
The FRNs are probably most suitable for investors who are “trying to get a better interest rate over a specific time period,” says Frank Fabozzi, a bond expert who teaches finance at EDHEC Business School in Paris and Princeton University. If you know you will need a sizable amount of cash in two years and are worried that interest rates might rise in the interim, the FRNs could make good sense.
Investors willing to lock up their money longer might be better off in bank certificates of deposit. A three-month CD from UmbrellaBank.com, an online division of Beal Bank of Plano, Texas, paid 0.51% annually this week, the highest rate available nationwide, according to Ken Tumin, editor of DepositAccounts.com, a website that researches interest rates on offerings from banks.
As financial planner Allan Roth of Wealth Logic, an investment-advisory firm in Colorado Springs, Colo., points out, CDs are ultimately backed by the federal government, just as Treasury securities are, since bank deposits (generally up to $250,000) are insured by the Federal Deposit Insurance Corp. So they offer comparable safety to that of Treasurys, but a higher yield.
Buy a five-year CD from Barclays at its recent 2.25% annual yield, pull your money out after two years and you will still earn an effective interest rate of 1.69% even after accounting for the bank’s penalty for early withdrawal, according to Mr. Tumin.
There isn’t any way of getting around one fact: In a world of low interest rates, investors have to work harder and be more resourceful to wring out more yield without sacrificing safety.
Update: Investors can buy floating-rate notes free of brokerage costs at TreasuryDirect.gov. An earlier version of this column incorrectly gave the website address as TreasuryDirect.com.
Source: The Wall Street Journal