Debt Management: Floating Rate Notes Can Help Treasury Meet Borrowing Goals, but Additional Actions Are Needed to Help Manage Risk
Published: 2014-06-16T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: To continue meeting its goal of financing the federal government's borrowing needs at the lowest cost over time, Treasury began issuing a new type of security—a 2-year floating rate note (FRN)—in January 2014. The FRN pays interest at a rate that resets periodically based on changes in the rate of the 13-week Treasury bill (to which the FRN is indexed). GAO was asked to review Treasury debt management, including this product and other debt management issues.
This report (1) evaluates Treasury's rationale for introducing FRNs and (2) identifies the demand for Treasury securities from a broad range of investors to assess whether changes would help Treasury meet its goals. To address these objectives, GAO used Treasury auction data from 1980 - 2014 to simulate the costs of Treasury FRNs, reviewed Treasury documents, surveyed a non-generalizable sample of 82 large domestic institutional investors across sectors, and interviewed market participants and academic experts. (For the survey and results, see GAO-14-562SP .)
section_title: What GAO Found
paragraphs: Issuing floating rate notes (FRN) is likely to help the Department of the Treasury (Treasury) meet its goals to borrow at the lowest cost over time, extend the average maturity of the debt portfolio, and increase demand for Treasury securities, but it also presents risks related to changes in interest rates.
GAO simulated the costs of 2-year Treasury FRNs using historical Treasury auction data and found that interest costs of the FRNs were generally less than costs of fixed-rate 2-year notes, but could be either more or less than costs of 13-week bills, depending on assumptions about how investors price the FRNs. GAO also found that in rising interest rate environments, the FRNs may be more costly than these alternatives.
Multiple components contribute to achieving lowest cost financing over time: issuing FRNs is part of Treasury's approach to achieving this goal. GAO analysis identified a number of design elements that may affect how FRNs contribute to that goal. Treasury officials believe it is prudent for Treasury to extend the average maturity of its debt portfolio because the debt level is already high and is expected to grow. Relative to issuing shorter-term debt, 2-year FRNs will help Treasury extend the average maturity of the debt portfolio and thereby reduce the risk inherent in going to market. Because the interest rate on a FRN can change during the life of the security, FRNs expose Treasury to the risk of rising interest rates whereas fixed-rate securities of the same maturity do not. These shifts in risk are likely to be small because currently FRNs are expected to constitute a small proportion of Treasury debt. Although managing interest rate risk is an important aspect of Treasury's goal to borrow at the lowest cost over time, Treasury does not track and report a measure of the average maturity of the portfolio that captures the additional interest rate risk of FRNs.
One element of the design of the 2-year FRN—the difference between the term of its index rate (13 weeks) and the length of its effective reset period (one week)—is not typical for floating rate notes and creates tradeoffs in interest rate risks but also may result in additional demand for the product. The risks could affect the pricing of FRNs and raise Treasury's borrowing costs in environments of high and volatile interest rates. Treasury officials told us they examined design elements, including this difference, before issuing the 2-year FRN. However, Treasury had not analyzed how the difference may affect FRN pricing.
FRNs give Treasury debt managers additional flexibility by increasing demand for Treasury securities and by adding a new security that meets the high demand for short-term securities. Results from GAO's survey of a broad range of investors and interviews with market participants found that market participants likely will purchase Treasury FRNs primarily as a substitute for other Treasury securities, but they will also purchase the FRNs as a substitute for non-Treasury securities, bringing new and potentially growing demand to Treasury. To provide the lowest cost of financing the government over time, Treasury must consider investor demand for new and existing products. Survey respondents indicated an interest in FRNs of additional maturities and in other new Treasury products. Treasury currently offers many ways for market participants to provide input, but GAO's survey identified opportunities for Treasury to enhance input from some sectors—including state and local government retirement fund managers.
section_title: What GAO Recommends
paragraphs: GAO recommends that Treasury (1) track and report a measure of interest rate risk in its debt portfolio, (2) analyze the price effects of the difference between the term of the index rate and the reset period, (3) examine opportunities for additional new types of securities, such as FRNs of other maturities, and (4) expand outreach to certain market participants. Treasury agreed with the recommendations and said that they had already taken steps to begin implementing them.

section_title: Letter
paragraphs: The U.S. Treasury market is the deepest and most liquid government  debt market in the world, and throughout history the Department of the  Treasury (Treasury) has been able to borrow the money it needs to  finance the federal government. In recent years federal debt held by the  public has risen dramatically, more than tripling in 10 years, from $3.9  trillion at the end of fiscal year 2003 to $12 trillion at the end of fiscal year  2013. The economic slowdown and global financial crisis that contributed  to this recent, rapid run-up in debt also brought about regulatory changes  and a “flight to quality”: this increased the demand for Treasury securities  and helped keep the interest rates that Treasury paid to its investors near  historic lows. Low rates meant that, while the debt more than tripled, the  interest expense on Federal debt held by the public increased by only 58  percent from fiscal year 2003 through 2013 to $248 billion. But with debt  projected to continue to grow and interest rates expected to rise, this cost  will increase.
To continue to meet its goal of financing the federal government’s  borrowing needs at the lowest cost over time, in 2013 Treasury  announced that for the first time in more than 15 years, it would begin  issuing a new type of security—a Treasury floating rate note (FRN). FRNs  differ from Treasury’s traditional fixed-rate notes in that the FRNs pay  interest at a rate that can rise and fall during the life of the security.
According to Treasury officials, FRNs will help Treasury to (1) borrow at  the lowest cost over time, (2) increase the maturity profile of the debt  portfolio, and (3) expand Treasury’s investor base by attracting new  buyers.
Floating Rate Note (FRN)  An FRN pays interest at a rate that is indexed  to another rate, which can rise and fall during  the life of the FRN. Treasury’s 2-year FRN is  indexed to the rate from Treasury’s most- recent 13-week bill auction.
You asked us to review Treasury debt management in the context of its  growing debt portfolio, including the introduction of FRNs. The objectives  of this report are to (1) evaluate Treasury’s rationale for introducing FRNs  and (2) identify the demand for Treasury securities from a broad range of  investors to determine whether changes would help Treasury meet its  goals. To address these objectives, we did the following:
Simulated the costs of 2-year FRNs, based on Treasury auction data  from 1980 to 2014 using two models, each with different assumptions  about the interest rates that Treasury would pay on the FRNs. We  compared those costs to Treasury’s actual costs of funding with 13- week bills and 2-year notes. We also analyzed how those costs varied  over different interest rate environments. For more information on our  cost simulations, see appendix I.
Reviewed the analysis Treasury conducted in developing the 2-year  FRN and the input Treasury received from market participants.
Administered an online survey to 82 (62 completed the survey) of the  largest domestic institutional holders of Treasury securities in the  following sectors: money market mutual fund managers, mutual and  exchange-traded fund managers, state and local government  retirement fund managers, retail and commercial banks, life insurance  providers, property-casualty insurance providers, and securities  broker-dealers. Respondents were selected to achieve 50 percent of  the total amount of Treasury holdings for each sector. The survey  results are not generalizable to all investors in Treasury securities. For  more information on our survey methodology, see appendix II. For  aggregate survey results reproduced as an e-supplement, see  GAO-14-562SP.
Interviewed market participants—including six primary dealers and  four asset managers—regarding the market for FRNs, the structure of  FRNs, other actions Treasury could consider to expand demand for  Treasury securities, and opportunities for investors to provide input to  Treasury.on their holdings of Treasury securities and their public comments on  Treasury’s FRN proposals. The views expressed in these interviews  are not generalizable to all market participants. Finally, we also  interviewed five academics recognized as having expertise in the  Treasury market, regarding the market for FRNs, the structure of the  FRN, and models for pricing the FRN.
We selected primary dealers and asset managers based  To assess the reliability of the data used in this study, including Treasury  auction data and information on the largest holders of Treasury securities,  we reviewed related documentation, conducted testing for missing data,  outliers, obvious errors, and traced data from source documents, where  possible and appropriate. To the extent possible, we also corroborated  the results of our data analyses and interviews with other sources. Based  on our assessment we believe that the data are reliable for the purposes  of this report.
We conducted this performance audit from April 2013 to June 2014 in  accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: To achieve its primary debt management objective of financing the  federal government’s borrowing needs at the lowest cost over time,  Treasury issues debt through a regular and predictable schedule of  auctions across a wide range of securities. Most of the securities that are  issued to the public are marketable, meaning that once the government  issues them they can be resold by whoever owns them.consists of bills, notes, bonds, Treasury Inflation-Protected Securities  (TIPS), and, since January 2014, FRNs (see figure 1). Currently,  Treasury issues bills with maturities ranging from a few days to 52 weeks;  notes with maturities of 2, 3, 5, 7, and 10 years; bonds that mature in 30  years; TIPS with maturities of 5, 10, and 30 years; and FRNs that mature  in 2 years.
section_title: Floating Rate Notes Are Likely to Help Treasury Borrow at the Lowest Cost over Time, Extend the Average Maturity, and Increase Demand, but They Also Present Certain Risks
subsections: section_title: 2-Year FRNs Are Likely to Cost Less than 2-Year Fixed-Rate Notes but Could Cost More or Less Than Bills, and the Cost Will Vary by the Interest Rate Environment
paragraphs: We analyzed the potential cost to Treasury of issuing 2-year FRNs and  found they are likely to have interest costs lower than 2-year fixed-rate  notes and not substantially different than 13-week bills. As a result, FRNs  will likely result in savings over the long run, helping Treasury achieve its  goal of borrowing at the lowest cost over time. Our simulations found  interest costs and savings varied depending on the security to which the  FRN is compared, how the FRN is treated by investors, and the interest  rate environment. We found that the cost of 2-year FRNs was generally  less than that of fixed-rate 2-year notes, but that it could be either more or  less than the cost of 13-week bills depending on assumptions regarding  investor treatment of the FRN. In addition, in all cases and in all  environments, savings tended to be greater—or added costs lower— under a model that sets the FRN spread based on its weekly reset than  under an alternative model where the FRN spread is influenced by its  final maturity of 2 years. We also found that, while issuing 2-year FRNs  generally results in cost savings, they may be more costly than other  alternatives in certain rate environments, such as rising rate  environments.
Prior to issuance of the first FRN, Treasury conducted its own analysis of  the potential cost of FRNs. Treasury’s analysis found that from 1982 to  2010, issuance of 2-year FRNs would have led to cost savings compared  to fixed-rate notes. Treasury’s analysis, however: (1) compared the cost  of 2-year FRNs only to 2-year notes and not to other alternatives, and (2)  assumed a fixed spread of 15 basis points (or 0.15 percentage points).
Floating Rate Note (FRN) Index Rate  The rate to which the interest rate of an FRN  is indexed. Treasury’s 2-year FRN is indexed  to the rate from Treasury’s most-recent 13- week bill auction.
To estimate the potential cost of FRNs to Treasury, we compared the cost  of hypothetical 2-year FRNs both to the cost of 2-year fixed-rate notes  and to series of rolling 13-week bills, using historical auction data from  January 1980 to March 2014 (see figure 5 below). We made these  comparisons using two models, each with different assumptions about the  spread over the index rate that Treasury would pay. We also compared  the cost of FRNs in the various interest rate environments.
Although it is uncertain what Treasury would issue in the absence of  FRNs, Treasury has indicated that, at least initially, the FRNs would be a  substitute for Treasury bill issuance. Both in interviews and in our survey  of large holders of Treasury securities, market participants also indicated  that they see the FRNs as a substitute for bills. However, Treasury has  also indicated that it intends to reduce the share of debt funded by bills in  order to increase its WAM. Without the 2-year FRN, Treasury might have  increased the WAM by the same amount by instead increasing its  issuance of 2-year fixed-rate notes, making them an appropriate  benchmark with which to compare the costs of the FRNs.
Our analysis used two models for how the FRN spread—the spread  between the index rate and the interest rate for the FRN—may vary over  time. The FRN spread is set at auction and is expected to vary in  response to changes in the level and volatility of interest rates. Because  there is uncertainty about how market participants will price the FRN  relative to other products, we considered two different models of the  response of spreads to changes in different interest rates:
A “maturity-based” model, where the spread estimate is influenced by  the 2-year term of the FRN.
A “reset-based” model, where the spread estimate is derived from the  weekly reset term, which determines the nature of the interest rate  risk faced by investors in FRNs.
These two models are designed to approximate the range of potential  spreads at which the 2-year FRN would have been expected to have  been auctioned in historical interest rate environments. For more details  on our models for FRN cost, including other models we considered, see  appendix I.
Because interest rate environments vary substantially over time, we also  compared how the cost of FRNs may vary based on changes in the level  and volatility of interest rates. Although these views are not  generalizable, market participants and experts we interviewed expect the  demand for FRNs to vary based on the interest rate environment. In  addition, 58 of 62 respondents to our survey indicated that FRNs would  be more attractive when interest rates are expected to rise; 49 of 62  indicated that FRNs would be less attractive when interest rates are  expected to fall.
subsections: section_title: Costs of 2-Year FRNs Vary Based on What Treasury Would Have Issued Instead, Investor Treatment of FRNs, and Interest Rate Environment
paragraphs: We found that compared to 2-year fixed-rate notes, FRNs are likely to  result in interest savings to Treasury regardless of how the FRN is treated  by market participants; however, compared to 13-week bills, they could  result in either savings or additional costs (see figure 6). Compared to 2- year fixed-rate notes, 2-year FRNs historically would have saved between  $8.1 million in interest costs annually per billion in issuance under our  maturity-based model, and $13.6 million under our reset-based model.  Compared to 13-week bills, the FRN would have resulted in annual  savings of $2.4 million per billion of issuance under our reset-based  model but additional annual costs of $3.1 million per billion of issuance  under our maturity-based model.
In addition to examining estimates of the relative savings and costs from  issuing 2-year FRNs, we also analyzed the share of cases in our  simulations where FRNs save or add to interest costs across different  interest rate environments (see figure 7). We found that compared to 2- year fixed-rate notes, the 2-year FRN would have resulted in savings in  82 percent of cases under our reset-based model and in 72 percent of  cases under our maturity-based model. Compared to 13-week bills, 2- year FRNs would have resulted in savings in 85 percent of cases under  our reset-based model but added to costs in 81 percent of cases under  our maturity-based model.
We also found that the interest savings or added costs from 2-year FRNs  varied with the interest rate environment regardless of how the FRN is  treated or whether it is being compared to 2-year fixed-rate notes or 13- week bills. Relative to 2-year fixed-rate notes, FRNs tended to be more  costly in rising rate environments compared to other environments.  Compared to 13-week bills, FRNs tended to be more costly (in the case  of our maturity-based model) or to produce less savings (in the case of  our reset-based model). The extra cost or reduced savings in rising rate  environments, however, tended to be less than the savings in steady and  falling rate environments. As shown in figures 6 and 7 above, under our  maturity-based model  in rising rate environments, 2-year FRNs were less costly than 2-year  fixed-rate notes in only 24 percent of cases and, on average,  increased Treasury interest costs by 0.48 percentage points, resulting  in $4.8 million in annual interest costs per billion in issuance; and  in falling rate environments, 2-year FRNs were less costly than 2-year  fixed-rate notes in all cases and, on average, reduced interest costs  by 2.07 percentage points, resulting in $20.7 million in annual interest  savings per billion in issuance.
We also analyzed the potential costs and savings from FRNs in  environments with different levels of rate volatility and found that, at all  levels of volatility, there was little variation between our two models. In  periods of low, moderate, and high volatility, 2-year FRNs tended to  produce savings compared to 2-year fixed-rate notes, but compared to  13-week bills, could produce either costs or savings, depending on which  model is used. In periods of extreme (i.e., higher than “high”) volatility,  FRNs produced savings under both models. For more information on the  results of this analysis, see appendix I.
section_title: Technical Demand May Increase Savings to Treasury, While a Liquidity Premium May Increase Costs
paragraphs: Factors other than interest rates may affect demand for FRNs, and  Treasury could realize additional savings from FRNs due to these  elements of technical demand. Both of the models we used to estimate  the cost of FRNs assume the FRN spread is based solely on the relative  value of FRNs compared to other Treasury securities. However, both our  interviews with market participants and our survey responses indicate that  demand for FRNs is also likely to be affected by technical factors, such as  investment guidelines or regulatory requirements to hold certain types of  investments. For example, Treasury officials and market participants told  us that Treasury structured the FRNs in a way that makes them  especially attractive to money market investors. To meet investment  guidelines and regulatory requirements, these funds tend to hold mostly  short-term securities like Treasury bills and, because their interest rate  resets frequently, FRNs.demand for Treasury FRNs that is less sensitive to the relative value of  the FRN. This generally would lower Treasury’s costs since some  investors would be willing to accept a lower interest rate at auction.
Technical Demand  Technical demand is driven by factors such as  investment guidelines or regulatory  requirements and is less sensitive to the  relative value of the security.
Our survey results confirm that technical factors affect the attractiveness  of FRNs for at least some investors. Twenty-seven of the sixty-two survey  respondents said that FRNs’ consistency with client or fund investment  guidelines make them attractive to a great or very great extent. Results of  our survey also show that 2-year FRNs are more attractive because they  conform to regulatory requirements for certain sectors. Six of the seven  money market mutual fund managers that responded to our survey  indicated that conformance with limits on their holdings make the FRNs  attractive to a great or very great extent. Similarly, five of the nine retail  and commercial banks that responded to our survey indicated that  conformance with new capital requirements made the FRNs attractive to  a great or very great extent.
Treasury’s costs could be increased if Treasury FRNs have a higher  liquidity premium than other Treasury securities. Debt issuers, including  Treasury, generally have to pay a liquidity premium on less liquid  products—products that cannot be easily bought and sold in large  volumes without meaningfully affecting the price—to compensate  investors for the possibility that they might not be able to sell the security  as readily as a more liquid product. A liquidity premium on FRNs that is  greater than the premium on other Treasury securities could increase  costs compared to our estimates. Although Treasury securities are  generally considered very liquid and have very low liquidity premiums,  market participants we interviewed said that FRNs might be less liquid  than bills—Treasury’s most liquid product—but more liquid than TIPS—its  least liquid product.because (1) investors are more likely to buy and hold rather than to trade  FRNs, and (2) FRNs are expected to have a smaller relative market size.  Several market participants said that liquidity is likely to be lower initially  and to improve as Treasury issues more FRNs.
section_title: Results of Initial FRN Auctions Were Within the Range Estimated by Our Models
paragraphs: The results of Treasury’s first three FRN auctions were within the range  estimated by our models. At the first FRN auction in January 2014, FRNs  were auctioned with an FRN spread of 0.045 percentage points. At the  February and March 2014 auctions, FRNs were auctioned with discount  margins of 0.064 and 0.069 percentage points, respectively.  The actual  auction results appear linked to the spreads predicted by our reset-based  model. In each of the three auctions, the actual auction results equaled  the spread predicted by our reset-based model plus a small and  consistent premium.
section_title: Mismatch Between the FRN’s Index Rate Maturity and Reset Frequency Poses Risk That Treasury Has Not Fully Analyzed
paragraphs: One element of the design of the Treasury 2-year FRN is that it is what  the market refers to as a “mismatched floater.” The difference (i.e., the  mismatch) between the term of its index rate (13 weeks) and the length of  its reset period (stated as daily, but effectively weekly) may introduce the  risk of price instability on the reset date that is not typical of most floating  rate securities. This is particularly the case if market participants treat the  FRNs more like series of rolling 1-week bills. This might affect demand for  the product in certain interest rate environments and, if so, could raise  Treasury’s borrowing costs.
In a Treasury FRN auction, bids are made in terms of a desired discount margin. The  highest accepted discount margin in the initial auction for a given FRN (which we refer to  as the FRN spread) becomes the spread for that FRN, and bidders pay the full value of  the FRN. At subsequent reopening auctions of the FRN, the spread is fixed based on the  results of the initial auction. Bidders at the auction still bid on a discount margin basis and  may pay more, less, or the same as the full value, depending on whether the discount  margin is less, more, or the same as the initial auction. most common index for non-Treasury floating rate notes—would typically  reset every 3 months. Absent a change in the credit risk of an issuer, the  value of a typical floating rate security returns to par—the value at  maturity—at each reset. This leads to a higher level of price stability in  floating rate securities compared to fixed-rate securities of the same  maturity. This price stability is highly desirable to some investors.
Yield Curve Risk  The risk that interest rates at different maturity  points—for example the rates for a one-week  bill and a 13-week bill—will change relative to  one another.
The Treasury 2-year FRN is different from a typical floating rate security  in that it will reset every week to a 13-week rate. This mismatch  introduces a tradeoff between yield curve risk and interest rate risk.  Unlike a typical FRN, the price of the Treasury 2-year FRN will not reliably  return precisely to par at each reset date before its 2 year maturity. This is  because investors factor in changes between the 1-week bill rate and the  13-week bill rate. However, the price of the Treasury 2-year FRN should  return close to par weekly, which is more frequent than if it had a 13-week  reset. Treasury officials told us they believe that the frequent resets  provide increased price stability for the FRN. They said that they expect  investors to price the 2-year FRN in a way that reflects the expectation  that the yield curve risk for Treasury’s 2-year FRN is likely to be small  relative to its reduced interest rate risk. However, if the difference  between the 1-week rate and the 13-week rate changes substantially over  the two year term, either in fact or in expectations, then the yield curve  risk that the investor faces would be more substantial. It is possible that in  higher and changing interest rate environments, the tradeoff between  yield curve risk and interest rate risk may not be favorable to investors.  This could be reflected in the spread, as investors bid for FRNs at auction  in a way that compensates them for this additional risk, which could raise  Treasury’s borrowing costs.
Money Market Fund  A money market fund is a type of investment  fund that is required by law to invest in low- risk securities. These funds have relatively  low risks compared to other mutual funds and  pay dividends that generally reflect short-term  interest rates. Money market funds typically  invest in government securities (including  Treasury bills and notes), certificates of  deposit, commercial paper of companies, or  other highly liquid and low-risk securities.
The mismatch between the index rate maturity and the frequency of the  interest rate reset could have adverse effects on the costs of FRNs to  Treasury. Treasury officials told us they discussed the design of the 2- year FRN both internally and with market participants and structured the  2-year FRN in this way for two reasons. First, as both those who  commented on Treasury’s proposal and Treasury have noted, the 13- week bill market is a large, liquid, and transparent market. Second,  Treasury designed the 2-year FRN to meet high demand for short-term  securities, and both Treasury officials and the market participants we  spoke with cited the 2-year FRN’s frequent reset as a reason for greater  demand from money market funds. These funds face constraints on the  average maturity of their holdings, which the weekly reset of the Treasury  2-year FRN helps address. This additional demand would likely result in  lower costs and helps establish the new product for Treasury, which may  outweigh the potential cost of the mismatch. Results of our survey show  that overall, the FRN’s index rate and the frequency of its interest rate  reset chosen by Treasury—as well as the difference between the two— made the FRN more attractive to investors (see table 1).
Although Treasury officials told us they discussed the potential benefits  and risks of the mismatch, Treasury had not analyzed how the mismatch  could affect pricing. After we briefed Treasury officials on the issue in  April 2014, Treasury began taking steps to study the mismatch to more  fully understand its potential pricing risks. While its practice of regular and  predicable issuance means Treasury issues all products in all  environments, it is important that the risks of different securities are  considered when making decisions about the mix of securities to issue.  Treasury did analyze and consider how other design elements would  affect pricing of the 2-year FRN and incorporated the results of that  analysis into their final design. For example, Treasury analyzed how  setting a minimum spread for the FRN would affect pricing. This analysis  led Treasury officials to conclude that a minimum spread would  unnecessarily complicate pricing, and it was excluded from the final  structure of the FRN.
section_title: FRNs Can Help to Extend the Maturity of the Debt Portfolio, but They Make Treasury’s Weighted Average Maturity an Incomplete Measure of Rollover Risk
paragraphs: Weighted Average Maturity (WAM)  The WAM of outstanding marketable Treasury  securities is calculated by averaging the  remaining maturity of all outstanding  marketable Treasury securities, weighted by  the dollar value of the securities. increase the maturity profile of the debt portfolio while meeting high  demand for high-quality, short-term securities. Treasury could extend the  average maturity of the portfolio by replacing issuance of shorter term  notes and bills with longer term fixed-rate notes and bonds, rather than  issue FRNs. In deciding what to issue, however, Treasury is confronted  with making prudent decisions about investor demand by product. If  Treasury issues the wrong mix of products, its overall cost of funding  would increase, as investors would express their preferences in prices bid  at auction.
Interest rate risk  For a borrower, such as Treasury, interest  rate risk is the risk of having to refinance  its debt at less favorable interest rates  and, for floating rate debt, of interest rates  rising during the life of the security.
The risk associated with coming back to  the market to refinance the debt. In times  of federal budget deficits, maturing federal  debt must be rolled over into new  issuance.
Treasury tracks the WAM of outstanding marketable securities and  publicly releases WAM data quarterly. Treasury debt managers do not  have a WAM target, but over the past 30 years they have generally kept  the WAM between 50 and 70 months (see figure 8). As of February 28,  2014, the WAM of the Treasury’s outstanding marketable debt was 67  months, well above the historical average of 58.6 months. As of January  2014, Treasury continued to increase the WAM in a way that Treasury  officials stated is consistent with their long-term objectives of financing the  government at the lowest cost over time and ensuring regular and  predictable management of the debt portfolio.
Marketable Debt  Marketable securities can be resold by  whoever owns them. In addition to marketable  securities, Treasury issues nonmarketable  securities that cannot be resold, such as U.S.  savings bonds and special securities for state  and local governments.
FRNs provide Treasury with additional flexibility in its debt issuance by  adding a new type of security to Treasury’s debt portfolio and by  increasing overall demand for Treasury securities. If a new security brings  incremental demand for Treasury securities, Treasury can grow its debt  portfolio without increasing by as much as it might otherwise have had to  the amount needed to finance the debt through existing securities. Our  interviews and survey results found that although market participants will  likely primarily purchase Treasury FRNs as a substitute for other Treasury  securities (especially bills), market participants will also purchase  Treasury FRNs as a substitute for other investment options, including  FRNs from other issuers and repurchase agreements (see figure 9).
Bid-to-Cover Ratio  In a Treasury auction the bid-to-cover ratio is  the dollar value of all bids received in the  auction, divided by the dollar value of the  securities auctioned. three FRN auctions; nevertheless, the rates quoted in the when-issued  market were very close to the auction results, an indicator that the  auctions came very close to market expectations. This suggests that the  price discovery mechanism of the market was functioning well for FRNs  and that the market embraces and understands the security, which in turn  indicates strong current and continuing demand that helps Treasury  borrow at lower cost over time.
When-Issued Market  When-issued trades are contracts for the  purchase and sale of a new security before  the security has been auctioned. When-issued  trades settle on the issue date of the new  security, when the security is first available for  delivery.
Our survey results suggest demand for Treasury FRNs is likely to grow.  Eighteen out of 61 survey respondents participated in the first Treasury  FRN auction, but more said they plan to purchase Treasury FRNs this  year. About half of all respondents (32 of 62) said their organizations   Survey  definitely or probably will purchase Treasury FRNs in 2014.respondents anticipate that money market mutual funds, corporate  treasuries, and foreign central banks are likely to have the most demand  for 2-year FRNs. Survey respondents noted a number of reasons why  Treasury FRNs are an attractive investment option, including the interest  rate risk protection they provide the purchaser, their price stability, their  use as a cash management tool, their consistency with investment  guidelines and regulatory requirements, and the liquidity of the securities.  The successful launch of a new type of security relies both on the  readiness of investors and on Treasury’s own operational readiness.  Overall, market participants felt prepared for the introduction of a new  security. According to almost all of the market participants we surveyed,  Treasury provided sufficient information regarding its plans to issue FRNs  (53 out of 62 respondents noted that Treasury provided sufficient  information and the remaining 9 noted that they had “no opinion or no  basis to judge.”) In addition, of the 48 survey respondents that said that  they would need to make systems changes to purchase FRNs, 36 said  that Treasury or the Federal Reserve had provided adequate assistance  or information to make the necessary changes. Some respondents noted  that as of March 2014, they had not yet completed systems changes that  will be needed to purchase FRNs. Demand for FRNs may increase as  additional investors complete systems changes.
Although issuance of FRNs brings incremental demand for Treasury  securities and demand in the initial auctions was high and is likely to  grow, one design feature of the 2-year FRN may constrain Treasury’s  flexibility in the issuance of 13-week bills. Treasury officials and market  participants both told us that because the FRN is indexed to the 13-week  Treasury bill rate, Treasury will have to be more judicious in adjusting the  size or timing of Treasury auctions of 13-week bills. As some comments  on the proposed rule noted, there is some risk in indexing a floating rate  note to a product from the same issuer. However, given that the 13-week  bill is one of Treasury’s largest and most liquid markets, its selection as  the index rate minimizes this risk.
section_title: Market Participants Identified Opportunities for Treasury to Enhance Investor Input and Expand Product Offerings
subsections: section_title: Overall Treasury’s Communication with Investors Is Strong, but Certain Sectors Said It Could Be Improved
paragraphs: As our prior work has found, communication with investors is essential as  Treasury faces the need to finance historically large deficits expected in  the medium and long term. Overall, survey respondents said that  Treasury provides sufficient information to investors on its debt  management plans. Forty-three out of the 62 survey respondents said  communication from Treasury occurred to a great or very great extent; no  respondents said communication occurred to little or no extent (one had  no basis to judge). In addition, most survey respondents said that they  were able to provide sufficient input to Treasury, but respondents from  some sectors reported lower levels of opportunity to provide input. The 26  respondents who reported opportunities existed to some or little to no  extent included 10 state or local government retirement fund managers, 4  money market mutual fund managers, and 3 life insurance providers (see  figure 10 below).
To manage risks associated with borrowing, Treasury monitors market  activity and, if necessary, responds with appropriate changes in debt  issuance based on analysis and consultation with market participants.  Treasury offers a number of ways for market participants to give input,  such as providing comments on regulations solicited through the Federal  Register and through the email box on the Treasury website. The  Treasury Borrowing Advisory Committee (TBAC) is comprised of senior  representatives from investment funds and banks and holds quarterly  meetings to provide insights to Treasury on the overall strength of the  U.S. economy and recommendations on debt management issues. In  addition, FRBNY administers the network of primary dealers that also  provide market information and analysis to Treasury. However,  Treasury’s Office of Debt Management does not meet regularly with all  sectors, such as state and local government retirement fund managers.  Survey respondent suggestions for improving communication with  Treasury included administering surveys, holding regular meetings or  calls with investors outside of the TBAC, polling investors on new product  ideas, and providing a mechanism for submitting annual  recommendations to Treasury from large investors. Without targeted  outreach to all major sectors of investors in Treasury securities, Treasury  could miss important insights to improve its debt management plans.
section_title: Survey Respondents Reported Interest Both in FRNs with Different Maturities and Other New Types of Treasury Securities
paragraphs: Responses from our survey of market participants indicate an interest in  FRNs of both shorter- and medium-term maturities, but respondents  expressed more limited interest in 7- and 10-year FRNs than in shorter- term FRNs (see figure 11). Survey respondents expressed the most  interest in the introduction of a 1-year FRN. Interest in the 1-year FRN  varied by sector, with mutual funds (including money market funds)  expressing substantial interest in this maturity, while retail and  commercial banks had little interest. Securities broker-dealers and state  and local retirement fund managers expressed the most interest in FRNs  with maturities other than 2 years, but other sectors—such as banks and  property-casualty insurance providers—also showed some interest in  these other securities. Treasury officials said they might consider issuing  FRNs with longer maturities once both they and the market gain some  experience with the 2-year Treasury FRN. Over the long run, Treasury  FRNs with maturities other than 2 years are likely to provide a cost  savings to Treasury relative to issuance of fixed-rate securities with the  same maturity.
Survey respondents expressed their views on certain design features of  FRNs with maturities other than 2 years. For instance, if Treasury were to  issue FRNs with different maturities, almost all survey respondents (57  out of 62) thought those FRNs should also be indexed to the 13-week  Treasury bill. More respondents said they would prefer daily interest rate  resets to any other reset period for FRNs with maturities other than 2  years. Of the respondents who wanted new FRNs to be indexed to the  13-week Treasury bill rate, 13 would also prefer daily resets for all  hypothetical maturities, including 4 state and local government retirement  fund managers and 5 securities broker-dealers. Although this suggests  that these respondents would prefer a “mismatched floater,” as discussed  earlier in this report, the mismatch feature may raise risks that result in  higher costs to Treasury in certain interest rate environments.  Additionally, respondents generally preferred quarterly interest payments  for FRNs with other maturities and monthly auctions for 1-year and 3-year  FRNs and quarterly auctions for FRNs with other maturities.
Survey respondents also expressed an interest in possible new Treasury  securities. Suggestions were ultra-long bonds, callable securities, FRNs  indexed to inflation, and zero-coupon notes or bonds (see figure 12).
In addition, respondents suggested that certain debt management  practices, specifically buybacks and reverse inquiry window, would  enhance demand for Treasury securities.that in general, changes to Treasury’s current debt management  practices—such as frequency of initial and reopening auctions, issuance  sizes, and non-competitive award limits—would not enhance demand  (see figure 13).
To achieve the lowest cost of financing the government over time, it is  important that Treasury spread debt across maturities and take into  account investor demand for new and existing products. The medium and  long term fiscal outlook make evaluating the demand for Treasury  securities, including new securities, increasingly important. Currently,  Treasury feels unable to conduct a broad survey of market participants.  For this reason, the insights on potential demand for new products from  our survey can provide Treasury with a starting point so that it does not  miss opportunities.
section_title: Conclusions
paragraphs: The U.S. Treasury market is the deepest and most liquid government  debt market in the world. Nevertheless, Treasury faces challenges in  managing the debt at a time when debt levels are high and projected to  increase and when interest rates are also expected to rise. Given the  market uncertainties and the federal government’s fiscal challenges,  increasing Treasury’s flexibility to respond to changing market conditions  in ways that minimize costs is prudent. FRNs are a tool that can help  meet these goals. Over the long term, FRNs can reduce Treasury interest  costs relative to fixed-rate securities that lock in funding for the same  term. FRNs can also help enhance Treasury flexibility by marginally  increasing demand for Treasury securities.
The design and implementation of FRNs has implications for Treasury’s  ability to minimize borrowing costs over time and for the balance of risks  in Treasury’s debt portfolio. Our cost analysis finds that in comparison to  issuance of 2-year fixed-rate notes, Treasury is taking on additional  interest rate risk but is likely to achieve interest cost savings while not  increasing market access risk. The mismatch feature of Treasury’s first  FRN presents a tradeoff between different risks for both investors and  Treasury that could raise Treasury’s borrowing costs when interest rates  are high and the yield curve is volatile. However, the mismatch also helps  Treasury tap into the current high demand for high-quality short-term  securities. Without analyzing how the mismatch between the frequency of  the reset period and the maturity of the index could affect pricing,  however, Treasury is unable to judge either (1) the risks (and therefore  the ultimate cost) of FRNs in a different interest environment, or (2)  whether the additional demand from money market funds due to the  mismatch feature outweighs the potential costs it creates. A better  understanding of these tradeoffs will be important when Treasury  considers issuing FRNs with maturities other than 2 years. Furthermore,  with the addition of FRNs to Treasury’s debt portfolio, the weighted  average maturity length of securities in the portfolio (i.e., the WAM) is now  an incomplete measure of rollover risk because it does not accurately  measure interest rate risk. Tracking and reporting an additional measure  of the length of the debt portfolio that captures interest rate risk could help  Treasury debt managers understand and weigh risks in the portfolio, and  publicly reporting that measure would facilitate transparency and market  understanding of Treasury debt management decisions.
Introducing FRNs at this time—when demand is high—can help Treasury  and market participants become more familiar with the new security so  that Treasury can expand to FRNs with different maturities if Treasury  determines that doing so would enhance its flexibility and advance its  debt management goals. It will also be important for Treasury to gauge  market demand for FRNs and other products by soliciting input from all  sectors of Treasury investors, specifically state and local government  retirement fund managers. Such input can help inform Treasury decisions  about changes to Treasury issuance or debt management practices that  could enhance overall demand for Treasury securities. When deciding  what to issue, Treasury must make prudent decisions about investor  demand by product. If Treasury issues the wrong mix of products, its  overall cost of funding will increase, as investors express their  preferences in prices bid at auction.
section_title: Recommendations for Executive Action
paragraphs: To help minimize Treasury borrowing costs over time by better  understanding and managing the risks posed by Treasury floating rate  notes and by enhancing demand for Treasury securities, we recommend  that the Secretary of the Treasury take the following four actions:  1.  Analyze the price effects of the mismatch between the term of the  index rate and the reset period;  2.  Track and report an additional measure of the length of the portfolio  that captures the interest rate reset frequency of securities in the  portfolio;  3.  Expand outreach to state and local government retirement fund  4.  Examine opportunities for additional new security types, such as  FRNs with maturities other than 2 years or ultra-long bonds.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this product and the accompanying e-supplement  (GAO-14-562SP) to Treasury for comment. On May 23, 2014 the  Assistant Secretary for Financial Markets told us that Treasury thought it  was an excellent report, that they agreed with the recommendations, and  that they had already taken steps to begin implementing them. For  example, he told us that Treasury’s new Office of State and Local  Finance will bolster outreach to investors in the state and local sectors.  Treasury also provided technical comments that were incorporated as  appropriate. Further, Treasury told us they had no comments on the e- supplement.
As agreed with your office, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 7 days from the  report date. At that time, we will send copies to the Secretary of the  Treasury, the appropriate congressional committees, and other interested  parties. In addition, the report will be available at no charge on the GAO  website at http://www.gao.gov.
Should you or your staff have any questions about this report, please  contact me at (202) 512-6806 or irvings@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on  the last page of this report. GAO staff who made major contributions to  this report are listed in appendix III.
section_title: Appendix I: Simulations of Floating Rate Note Costs
paragraphs: To estimate the potential cost of floating rate notes (FRN) to Treasury, we  simulated the costs of 2-year FRNs based on Department of the Treasury  (Treasury) auction data from January 1980 to March 2014 using two  models, each with different assumptions about the spread over the index  rate that Treasury would pay. We compared those costs to Treasury’s  actual costs of funding with 13-week bills and 2-year notes. We also  analyzed how those costs varied over different interest rate environments.
subsections: section_title: Estimating Spreads
paragraphs: To estimate the range of potential costs from FRNs, we used two models  of the costs of FRNs to Treasury:  1.  A “maturity-based” model where the spread estimate is influenced by  the 2-year term of the FRN.
In the maturity-based model, the FRN spread—the difference  between the index rate and the interest rate on the FRN—split the  difference between the 13-week bill and 2-year note yields on the date  of the FRN auction:  This model was suggested to us by a market participant as one way  to estimate the likely spread for the Treasury FRN, and we found it to  be reasonable.  2.  A “reset-based” model where the spread estimate is derived from the  weekly reset term, which determines the nature of most of the interest  rate risk faced by investors in FRNs.
This frequently results in a negative FRN spread, meaning that, under  this model, the FRN generally has a yield lower than a 13-week bill.  We allowed for negative spreads under this model because Treasury  regulations allow the FRN to auction with a negative spread and, in  very low interest rate environments, short term bills on the secondary  market have sometimes traded with a negative yield.
While we considered other models for determining the cost of FRNs,  these two models are designed to approximate the range of potential  spreads Treasury’s 2-year FRN would be expected to have been  auctioned at in historical interest rate environments. We also considered  models based on:
FRNs from government-sponsored enterprises (GSEs). Several  market participants we spoke with indicated that FRNs issued by  Fannie Mae and Freddie Mac would be the closest comparison for  Treasury FRNs. However, we determined that GSE FRNs were not  sufficiently comparable for our purposes due to the issuance practices  and FRN structures used by Fannie Mae and Freddie Mac.
Swap prices. Several market participants also suggested interest rate  and asset swaps could be used to estimate spreads on Treasury  FRNs. We reviewed results of simulations of FRN spreads published  by one market participant, and found the estimates from this model  usually to be within our own estimates for the FRN spread.
Theoretically derived formula. We explored modifying the formulas  used in Don Smith’s “Negative Duration: The Odd Case of GMAC’s  Floating-Rate Note” to derive a theoretically correct spread price.
This approach predicted FRN spreads comparatively very close to  zero and which generally lie within the costs predicted by the maturity-  and reset-based models. This pricing model did not incorporate the  pricing consequences of the mismatch between the reset rate and the  maturity of the index, and so does not fully capture the pricing risks  faced by the FRN.
section_title: Defining Interest Rate Environments
paragraphs: Because interest rate environments vary substantially over time, we  compared the relative costs of the FRNs in various interest rate  environments. The different environments, as used in our analysis and  discussed in our report, are described below (see table 2).
To determine the trend of 13-week yields over a two year period, we  estimated a linear time trend on the first difference of weekly yields  (where t is an index of the number of weeks since the start of the two- year window):  This is essentially equivalent to fitting a second degree polynomial to the  yields, allowing us to capture changes in direction of the interest rate  trend (i.e., peaks and troughs) as well as the slope of a linear trend. The  estimated curves were used in classifying the interest rate environments.
The cut-offs for assigning an interest rate trend to a category of rising or  falling—versus steady—were based on our professional judgment. Other  approaches—such as using traditional statistical significance tests— conflate volatility with assessment of the presence of a trend and  therefore are not appropriate for this determination.
We were able to use a data-derived approach to assign 2-year periods to  our volatility categories. We use the RMSE statistic as an aggregate  measure of the weekly yields’ total deviation from the trend. We then  used a k-mean cluster analysis to divide the sample into four volatility  groups: low, moderate, high, and extreme.
section_title: Estimating Interest Costs
paragraphs: Using the maturity- and reset-based models, we estimated what the  spread would be for FRNs auctioned on the same day as actual 2-year  fixed-rate notes from January 1980 to March 2012, resulting in 387  simulated FRNs. We then applied these estimated spreads to the actual  weekly 13-week bill auctions from January 1980 to March 2014, and  calculated what the total interest cost would have been for each simulated  FRN during this period. Like the actual 2-year FRN, we used a floor of  zero for the daily interest accrual of our simulated FRNs.
To determine the relative interest cost of the FRN, we compared the  estimated costs of the simulated FRNs to the costs of the actual 2-year  fixed-rate notes and a rolling series of 13-week bills for each 2-year  period. We estimated the average interest costs relative to 2-year notes  and 13-week bills as well as the percent of cases where FRNs generate  savings or additional costs compared to bills or notes.
section_title: Results of Simulations of FRN Costs by Volatility in Rates
paragraphs: In addition to the results presented in the body of our report, we estimated  the cost of 2-year FRNs by volatility of the rate environment. As shown in  figures 14 and 15 below, we found that, at all levels of volatility, there was  little variation between our two models. In periods of low, moderate, and  high volatility, 2-year FRNs tended to produce savings compared to 2- year fixed-rate notes, but could produce either costs or savings compared  to 13-week bills depending on which model is used. In periods of extreme  volatility, FRNs produced savings under both models.
section_title: Appendix II: Survey Scope and Methodology
paragraphs: To address both of our objectives, we surveyed and interviewed market  participants regarding (1) the market for FRNs, (2) the structure of FRNs,  (3) other actions Treasury may consider to expand demand for Treasury  securities, and (4) communication between Treasury and investors. To  gather information from a broader range of investors, we administered an  online survey to 82 of the largest domestic institutional holders of  Treasury securities in the following sectors: money market mutual fund  managers, mutual and exchange-traded fund managers, state and local  government retirement fund managers, retail and commercial banks, life  insurance providers, property-casualty insurance providers, and securities  broker-dealers (see table 3). Results of the survey are not generalizable.  For aggregate survey results reproduced as an e-supplement, see  GAO-14-562SP.
To identify sectors for our sample, we reviewed data from the Federal  Reserve’s Financial Accounts of the United States, (table L.209, third  quarter 2013) to identify which sectors have at least $60 billion in  Treasury holdings. We excluded some sectors due to challenges in  contacting certain entities, such as foreign monetary authorities, other  foreign investors, and the household sector.
To identify the organizations within each sector that would receive our  web-based survey, we used rankings of the largest organizations in each  sector based on total assets or an equivalent financial indicator, such as  assets under management or direct premiums written. From these ranked  lists, we determined Treasury holdings for each organization and selected  as many organizations as needed to represent at least 50 percent of the  total amount of Treasury holdings for that sector (based on table L.209 of  the Federal Reserve’s Financial Accounts of the United States) or in the  case of mutual funds, exchange traded funds, and money market funds,  based on information from the Investment Company Institute on total  assets under management in Treasury- and government-focused funds.
section_title: Appendix III: GAO Contacts and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Tara Carter (Assistant Director),  Susan E. Murphy, (Analyst-in-Charge), Abigail Brown, Emily Gruenwald,  Daniel Ramsey, and Albert Sim made key contributions to this report.  Amy Bowser, Dianne Guensberg, Stuart Kaufman, Risto Laboski, Donna  Miller, Dawn Simpson, and Stewart W. Small provided subject matter  assistance.