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.
Tying U.S. debt costs to how interest rates rise and fall could also be dangerous. For every $1 billion in floating-rate debt that the Treasury issues, a 0.5% (50 basis point) increase in interest rates would result in its debt costs rising by $5 million. You can imagine how quickly U.S. debt costs could rise if the government had something like $1 trillion in floating rate debt and interest rates jumped a few percent in a year. Suddenly, the government would have to issue tens of billions of dollars in additional debt just to keep up with rising interest rates.
And if you think that the government puts too much pressure on the Federal Reserve to act now, just wait until it directly controls a portion of the nation's interest costs. Floating-rate note would likely include a benchmark rate controlled by the Fed. So if the U.S. is ever struggling to meet its debt obligations, the Fed may feel obligated to keep interest rates lower than it otherwise would. If it increases rates, a payment shock could affect U.S. financial stability. Due to this, floating-rate debt could lead to higher inflation, since the Fed may feel pressured to leave interest rates lower for longer.
Finally, it might be preferable for investors to have interest rate risk instead of the Treasury. Investors are likely savvier about mitigating that risk. They can buy interest rate hedges if they're worried. They can attempt to quickly sell a portion of their portfolio if they anticipate rates changing. The Treasury isn't as expert or nimble at managing this risk. This could ultimately result in taxpayers paying more for debt, since the government won't be as skilled at dealing with minimizing the cost of rising rates.
No Natural Hedge
Often, floating-rate debt is sold by issuers who have some natural hedge that makes it easier for them to stomach interest rate risk. For example, if you've got a pool of adjustable-rate mortgages, then it makes sense to sell floating-rate mortgage-backed securities. The interest you've got coming in on those mortgages will make it easy to bear the interest rate risk of the debt. Similarly, if you've got fixed-rate mortgages, then you can more easily pay interest on fixed rate mortgage securities.
How does the government fit in here? On some level, it should be easy for it to bear the cost related to interest rate risk: it's got virtually unlimited resources as far as the market is concerned. But really, its revenue doesn't change based on how interest rates move -- it's based on tax rates that have nothing to do with interest rates. So the U.S. would not have a natural hedge to the interest rate risk it would be taking on. Still, paying a little extra to issue floating rate notes could be a good idea under certain circumstances: it provides another tool to ensure that the government can cope with its growing debt burden.
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