Adding Up the Risks in Floating Rate Debt
November 9, 2013 Leave a comment
NOVEMBER 8, 2013, 1:12 PM
Adding Up the Risks in Floating Rate Debt
It’s basic corporate finance that bonds involve two basic risks: interest rate risk and payment risk. So what happens if a risk-free issuer puts out floating rate debt? We are about to find out, since the Treasury Department announced this week that it would soon start issuing two-year debt that would pay interest at the rate of the most recent 13-week Treasury bill rate, plus a spread set at the time of the initial sale. I think we can assume that the spread will be quite small, perhaps nonexistent.So buyers essentially gets the same effect as rolling their money into a short-term Treasury bill over a two-year period, without any transaction costs. Or maybe we can see it as a short-term Treasury bill swap, again without transaction costs.
Such an investment would have a real return — the return after inflation — of zero. As a matter of theory, of course.
In times of crisis, the short-term Treasury bill rate is apt to have a negative real return, so that will show up here, too. And what if there is so much demand for the new floating rate notes that the spread is a negative number? Then, you end up getting negative real return, too.
But that ignores the biggest risk, which, in theory, should not exist at all: payment risk. A sovereign borrower borrowing in its own currency — in this case, that currency is also the leading reserve currency — should theoretically have no payment risk.
But theory does not account for the risks of irrationality. In particular, the reckless tendencies of Tea Party Republicans, who seem to be willing to do things best done outside the real world. Like landing a 747 on an aircraft carrier. Or defaulting on United States government debt.
That means these new floating rate instruments may give us a new way to measure the actual costs of Washington’s dysfunction. The difference between the return of short-term Treasury bills and the new floating rate notes will be the price of having your investment strapped to a political thrill ride for two years.
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