Would taxpayers be better off or worse off if investors could buy U.S. debt that pays more when interest rates rise?
Interest rates won't be ridiculously low forever. Although the Federal Reserve has been on a crusade over the past few years to keep both shorter- and longer-term interest rates extraordinarily low, it will eventually have to allow them to rise as the economy improves. At that time, investors could demand much higher fixed rates to cover the interest rate risk they're taking. This could have consequences for Treasury securities, which have interest rates that do not adjust as market rates change. Reports indicate that the government is mulling offering floating-rate securities to make U.S. debt more attractive to investors.
First, just to be clear, the Treasury does not appear to be planning to issue floating-rate bonds in the near future. It has considered issuing floating-rate securities in the past, but has never done so. It's currently exploring the option again, however.
It might be particularly interested in this possibility now. Both short- and long-term interest rates are near historical lows. This means that any investors locked in to Treasuries for an extended period could see the value of those securities decline significantly if rates begin to rise. Eventually, they'll have to.
Why This May Be a Good Idea
Obviously, investors would love to eliminate the interest rate risk they face when purchasing Treasury securities. Up to now, this risk has just been baked into the prices of these securities. For that reason, the Treasury -- and taxpayers -- could benefit by selling adjustable-rate Treasury securities.
f the government takes on that risk instead of allowing it to be priced into the securities by the market, then its borrowing costs will be lower when investors expect rates to rise. In that situation, they will be paid a lower interest rate until rates begin to rise.
For example, as of Friday 10-year Treasury yields were around 2.25%. If over the weekend some news came out that implied that interest rates were going to rise dramatically over the next few years, then investors would demand higher interest rates immediately. Perhaps 10-year Treasury yields would rise to 4% this week. But if that expectation proves incorrect and interest rates don't rise, then the Treasury would have paid a premium for its inflexibility over the period during which the market expected higher rates.
Floating-rate securities could work to the Treasury's advantage in an environment where significant interest rate uncertainty clouds the market. In such a situation, investors will demand relatively high fixed rates, if they'll accept fixed-interest rate securities at all. Since the Treasury must roll over a great deal of its debt constantly, it doesn't want to run into a problem where too few investors are demanding Treasuries at reasonable interest rates. By selling floating-rate notes, it doesn't have to worry about this problem.
Why This May Not Be a Good Idea
But selling floating-rate debt could have some negative consequences. For starters, the Treasury would not be able to lock-in low fixed rates for an extended period. For part of September, for example, 30-year notes were at yields below 3%. Any 30-year debt issued over that period puts the Treasury in a great position for the next three decades: long-term rates may never be so low again. If it had issued floating-rate notes instead, however, then its debt costs would rise over those three decades as rates rise.