Wells Fargo Advantage Money Funds' latest Portfolio Manager Commentary "Overview, strategy, and outlook" discusses the Treasury's pending FRN program. It tells us, "On November 6, the U.S. Treasury announced it would conduct its first auction of floating-rate notes (FRNs) on January 29, 2014. This is a notable event because it is the Treasury's first new product in 17 years. The FRNs will have a maturity of two years and an interest rate that resets daily based on the most recent 13-week Treasury bill (T-bill) auction rate plus or minus a spread that is set at the auction. The first auction is expected to be for an amount of $10 billion to $15 billion, with additional sales of the same issue, called reopenings, at the end of each of the next two months, for a total issue size of perhaps $40 billion. This auction schedule would allow for four distinct maturities, totaling in excess of $150 billion, to be issued each year."
Wells explains, "There will be a period of price discovery in the initial auctions, as some investors seek an early-adopter discount while others may wait for the dust to settle before becoming involved. Buyers are expected from the usual population of T-bill and other short-term Treasury investors, including money market funds, central banks, and entities needing high-quality liquid assets (HQLA) to meet the various upcoming regulatory requirements we discussed in last month's commentary."
They continue, "This leads to an important realization about the FRNs: despite being new and exciting, they aren't likely to significantly change either the supply or demand dynamic in U.S. government money markets. As mentioned above, the demand from buyers who want, or need, to own Treasuries will continue to be robust. On the supply side, the Treasury's total issuance is always based on its cash needs, meaning the cash raised by issuing FRNs will come at the expense of issuing other instruments. Given the Treasury's drive to extend the average maturity of the country's debt during this post-financial crisis period of heavy deficits, FRN issuance seems most likely to replace T-bill issuance. This brings up the interesting point that the Treasury has the opportunity to influence the 13-week T-bill auction rate by shrinking the auction size. Investors could pick up additional yield in the FRNs' spread to the index but give some yield back down the road as the index may be lower than it otherwise would be due to a scarcity of T-bills."
Wells writes, "When it all shakes out, FRNs will probably be yield-positive for investors who buy them in lieu of T-bills. FRNs are a longer-term instrument than the T-bills they replace, so they should yield more. As a risk-free instrument, credit shouldn't be a concern, but gauging the correct yield spread for two years will be more challenging. On that note, the Continuing Appropriations Act, 2014 suspended the debt limit for the U.S. until February 7, 2014, just one week after the first FRNs are due to settle. Depending on the temperature of the topic in the news at that time, this may affect the initial FRN auction as well. Questions about creditworthiness could lead some to avoid the auction, but conversely, the FRNs could be seen as more desirable than T-bills as their final maturity is far in the future, long past any political wrangling from the current episode."
Finally, they say, "Although these new FRNs won't materially change the supply/demand dynamic, for investors who are limited by their charters to investing in U.S. Treasury obligations, this new product is, in fact, pretty exciting. For Treasury-only money market funds, this is very friendly for the weighted average maturity (WAM), which is limited to 60 days, because the interest-rate reset of one day allows them to mark the maturity in a corresponding manner for this calculation, which will push a fund's WAM lower. A constraining effect, however, is the FRN's final maturity of two years, which will push a fund's weighted average final maturity (WAFM) much higher. With a fund's WAFM capped by SEC Rule 2a-7 at 120 days, this means a fund could only put a maximum of 16% of its assets in two-year FRNs if the rest of the fund was strictly in overnight investments. Given these factors, Treasury-only funds are likely to want to buy the FRNs for additional yield and their lowering effect on WAM but will be limited to a fairly small involvement due to the WAFM restrictions. Prime funds and government funds able to invest in more than just Treasuries are likely to be less motivated to buy the FRNs given their access to higher-yielding alternatives."
