Given the Treasury's introduction of their new 2-year floating rate notes last week, we wanted to excerpt some more commentary on these new securities. (Watch for our next Money Fund Portfolio Holdings dataset early next week, which will contain the first glimpse of live MMF FRN holdings as of Jan. 31.) Below, we quote from Wells Fargo's special report, "The 2-Year Treasury FRN," and from J.P. Morgan Securities' most recent commentary. Wells' Garret Sloan wrote last Wednesday, "The first FRN auctions today, Wednesday, January 29th and will settle on Friday, January 31. The Treasury expects to issue FRNs on a quarterly basis with monthly reopenings occurring between the quarterly auctions. The quarterly auctions will settle on the last calendar day of the month, or the first business day after, and the reopenings will settle on the last Friday of the month, or the first business day after. The size of the first auction is $15 billion, and the size of each auction and reopening is expected to be in the $10-15 billion range, putting total FRN issuance in the $120-180 billion range for 2014. Bill issuance as a percentage of total marketable debt has steadily declined over the last 5 years and is expected to continue to do so as the growth of the FRN program will likely be at the expense of the bills market."
Wells explains, "FRNs will reset daily and the interest calculation is based upon a reference rate plus a spread. The reference rate is the High Rate from the most recent 13-week T-bill auction which typically occurs every Monday, or the next business day if it falls on a holiday. However, FRNs will have a two-day lock-out period prior to the auction settlement date or interest payment date. So if the most recent 13-week bill auction falls during that lock-out period, the High Rate from the previous week's auction is used as the reference rate. FRNs are technically a daily reset security, but effectively the rate will only change once a week since the 13-week bill auction occurs once a week."
They add, "We believe that a daily reset was chosen to reduce the impact of the 2-year FRNs on money market fund portfolio weighted average maturity calculations, which must be less than 60 days. While the FRNs will still be considered 2-year securities for the money market funds' weighted average life calculations, on balance we believe that the 2-year Treasury FRNs could actually be favored by money funds as a source of liquidity vs. T-bills, especially if they trade at favorable spreads."
J.P. Morgan Securities' latest weekly "Short-Term Fixed Income" tells us, "This past Wednesday, Treasury auctioned its inaugural 2y floating rate note (FRN) to strong demand. The new issue priced at a spread of 4.5bp over 3m bills, slightly through our initial expectation of +5bp. The bid-to-cover ratio, commonly used as indicator of Treasury demand, was 5.67 which is high compared to any other Treasury auction.... Not surprisingly, investor participation on this new issue was relatively broad based. Anecdotally, we had heard that some short duration mutual funds, separately managed accounts and insurance funds came in for the auction. Many of these investors have a common trait, which is that they are benchmarked to bills, thus motivating them to subscribe to the auction as long as there's a positive spread. This group of investors manages liquidity pools right outside of the 2a-7 space (i.e., slightly longer duration), so this product is seemingly a natural fit for them."
JPM's update, written by Alex Roever, Teresa Ho and Chong Sin, continues, "Notably, money fund participation appears relatively light, contrary to our initial expectations. While some funds participated in light of the decline in money market supply, others did not. Generally, this latter group of accounts found the floaters too expensive and was not compelled to invest at this time. Since Treasury intends to issue FRNs each month, either in re-openings or new issue, some investors felt there was no urgency to invest and instead took this opportunity to see how secondary market liquidity develops for the product. Furthermore, concerns around the debt ceiling might have contributed to their absence."
Finally, they add, "Looking ahead, though we're confident that there will be enough investor support for Treasury FRNs, it's unclear how investor demand for this product will exactly evolve. The mix of investors and their participation rate will likely change over time. For example, while money funds are likely a receptive investor base for Treasury FRNs, their demand may be limited by the different types of funds and the various government and rating agency rules that govern what they can buy. In particular, both Rule 2a-7 and most rating agency rules place a weighted average life (WAL) restriction that limits the portfolio's average time to final maturity to 120 day."
