US: 2-Yr FRN Note Auction

September 22, 2021 10:30 CDT

Actual Previous
Total Amount $26 B $26 B
Bid/Cover 2.84 3.17
Discount Margin 0.026% 0.026%
CUSIP Number 91282CCQ2 91282CCQ2
Originally Announced CUSIP 91282CCQ2 91282CCQ2

Results are soft for the monthly 2-year Floating Rate Note (FRN) auction, where coverage, at 2.84 was the lowest since January and demand from end investors was tepid, with non-dealers taking down 57 percent of the $26 billion offering. The high discount margin was awarded at 0.026 percent, unchanged from last month's rate.

An FRN (floating rate note) is a security that has an interest payment that can change over time. As interest rates rise, the security's interest payments will increase. Similarly, as interest rates fall, the security's interest payments will decrease. Yields on 2-year Treasury FRNs are reset each week to reflect the most recent weekly 3-month (13-week) Treasury bill auction high discount rate. But in addition to the weekly reset 3-month high discount rate, FRN yields include a discount margin (which in the first issue becomes the spread that not unlike a coupon becomes fixed to the FRN and is factored in for all subsequent discount margin rates) paid on top of the 3-month high discount rate. FRNs are sold at regularly scheduled public auctions. The competitive bids at these auctions determine the high discount margin for the FRN issue in addition to the 13-week floating high rate. A group of securities dealers, known as primary dealers, are authorized and obligated to submit competitive tenders at Treasury auctions. Dealers can hold the FRNs, resell them to their clients or trade them with other securities firms. Typically, the New York Fed approves about 20 securities firms to be primary dealers but that number dropped sharply during the 2008 financial crisis as some were merged into other firms or went bankrupt. The Fed has been rebuilding that number regularly and the latest list can be found here. Floating rate notes offer investors a chance to gain yield when interest rates rise and offer investors a low risk, high quality alternative to Treasury bills and their associated rollover costs. Original issue 2-year FRN auctions are usually announced in the second half of January, April, July and October, while reopening auctions are announced in the second half of each of the remaining months of the year. 2-year FRN auctions are always held in the last week of each month. Original issue FRNs are issued on the last day of the month, unless it is a non-business day, in which case they are issued (settled) on the first business day of the following month. The reopenings are issued on the last Friday of the month.

Individual investors can participate in Treasury auctions either through a securities dealer (brokerage firm) or via the Treasury Direct program, which saves on brokerage commissions. But brokers commissions are often nominal (especially with discount brokers), and using a broker does eliminate a lot of paper work and other administrative hassles. Brokers facilitate the purchases and sales of Treasuries in the secondary market, which is handy for buying Treasuries at times other than scheduled auctions or for maturities other than those offered by standard new issues.

Interest rates on Treasury securities are determined in the market; the Federal Reserve does not set them. However, bond investors are sensitive to Federal Reserve policy and thus market rates will mirror policy expectations. Usually, bond market players are forward-looking and this means that interest rates on Treasury securities will move in the direction of Fed policy with a lead. As a result, one is more likely to see rising interest rates on Treasury yields during an expansion (and falling yields during economic slowdowns) in advance of policy changes by the Federal Reserve.

Introduced in 2014, the FRN is the first addition to the Treasury's offerings since inflation protected notes were introduced in 1997. Floating rate notes offer investors a chance to gain yield when interest rates rise, so that holders of FRNs benefit most from rapidly rising rates, in contrast to holders of fixed coupon securities, who are often subjected to substantial price declines in such a scenario. The risks of holding FRNs are minimal, since price movements are small due to the built-in weekly convergence to the 3-month T-bill rate. Investors who are risk averse and normally invest in Treasury bills on a revolving basis by rolling over the redeemed cash upon maturity into the next T-bill issuance may find FRNs attractive because of the convenience and the savings they offer in rollover costs.

Primer on Treasuries
Treasury securities, Treasuries, U.S. government bonds, T-bonds, T-notes, T-bills. TIPS and FRNs all refer to the same type of security: debt obligations of the United States. Maturity refers to the length of the loan to the government. T-bills are offered in maturities up to one 1 year, most commonly as the 4-week bill, 3-month bill, 6-month bill and the 52-week bill. TIPS, which were first offered in 1998, have maturities of 5, 10 or 30 years. Treasury notes have maturities from 2 to 10 years (2-, 3-, 5-, 7- and 10-year notes are most common), while T-bonds offered by the Treasury have a maturity of 30 years. The Treasury only offers FRNs with an initial 2-year maturity. In 2008, the Treasury ruled that all securities it issues now have minimum denominations of $100 and must be purchased in increments of $100.

How FRNs work
The principal amount purchased is redeemed at maturity. Interest on FRNs accrues daily and is paid quarterly. The accrual rate resets each week according to the result of the most recent 13-week T-bill auction plus a spread determined by competitive bids at the original issue FRN auction, subject to a minimum net yield of zero percent. For purposes of calculating auction settlement amounts and quarterly interest payments, floating rate notes have a two-business-day lockout period prior to their auction settlement date or interest payment date. Therefore, a 13-week Treasury bill auction whose rate becomes effective during the lockout period will be excluded from the calculation of accrued interest for purposes of determining that settlement amount or interest payment. Any changes in the index rate that would otherwise have occurred during the lockout period will occur on the first calendar day following the end of the lockout period.
You pay $1,000 for a 2-year FRN and receive interest payment every 3 months based on the accumulated accrued interest at the high rate for each of the 13-week T-bill auctions during the period plus a spread determined by competitive bids at the FRN auction. If, for example, the high rate remains at 4% for each of the weekly 13-week T-bill auctions during the first year, and the spread established during the original issue auction is 1%, you will receive $12.50 every 3 months for a total of $50 for that year. When the FRN reaches maturity in 2 years you will have received a total of 8 interest payments (if interest remained the same in the second year for a total of $100) and you will get back your initial investment (the principal) on the maturity date. The Treasury publishes tables listing the daily accrual rate for all issued FRNs.

Investment Profile
Treasuries offer a measure of security unmatched by other investments - the U.S. government guarantees the initial investment (the principal) and the interest payments. FRNs offer an additional level of security, protecting the investor from the price depreciation suffered by fixed-rate treasuries during periods of rising interest rates. Floating rate notes have increased returns when interest rates rise, so that holders of FRNs benefit most from rapidly rising rates. Since price movements are small as the yield always converges weekly to the 3-month T-bill rate, the risks of holding FRNs are limited to the lost opportunity to profit from declining interest rates offered by fixed-rate Treasuries.