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Finally, a Bond That Might Be Worth Buying

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For years, smart bond investors have realized that locking in low rates on bonds only makes sense if you think that you'll be able to sell them at a profit at some point in the future. With worries that rising rates could crush their portfolios, investors haven't seen bonds as having a very attractive risk-reward proposition for some time.

Now, though, the U.S. Treasury has realized that with its need to borrow huge amounts of money, it needs to find ways to appeal to scared bond investors who want to make sure they're protected against a sudden and dramatic rise in interest rates. To do so, the Treasury is planning to issue a brand-new type of bond that has a feature that has never been seen before in Treasuries: a floating interest rate.

Why now?
The Treasury has had floating-rate debt offerings in the works for more than a year now. Now, though, it believes that it will get the necessary rules in place to govern issuance of floating-rate notes within the next several months and will issue its first notes under the new program within the next year.

Part of the reason for the urgency is the debt-ceiling debate, which was recently pushed back by a couple months but which still looms at the top of the Treasury's agenda. With the likely need to take extraordinary measures in order to prevent a debt default, the Treasury is looking at a wide variety of moves to try to broaden the appeal of Treasury securities. In addition to the new floating-rate debt, the agency expects to issue more Treasury Inflation-Protected Securities in the near future as well, and the group looked at the possibility of issuing longer-dated debt with maturities as far as 50 years into the future.

How would floating-rate bonds work?
Currently, most Treasury bonds carry fixed interest rates that are determined at auction. By contrast, to offer a floating-rate note, the Treasury would first have to decide what benchmark rate would be used to calculate the floating rate. One of the most likely choices would be the auction rate on 13-week Treasury bills, although other alternatives also exist that could work equally well.

In auctioning the floating-rate bonds, investors would then decide how much additional yield they would want above that benchmark rate. Over time, as the benchmark rose and fell, the interest payments that investors would receive would rise and fall with it.

A smart investment?
In the past, corporate issuers have given investors the chance to buy floating-rate notes. Most of the focus was on notes that allowed access to money at any time, differing from the floating-rate Treasuries under consideration because of their lack of a fixed maturity. But General Electric (NYSE: GE  ) , which has issued these notes for more than 20 years, offers term notes as well, and more recently, Duke Energy (NYSE: DUK  ) has gotten into the area, first issuing notes to employees and then opening them up for a broader audience. Ford (NYSE: F  ) and Caterpillar (NYSE: CAT  ) have also offered similar securities, giving investors a chance at better rates than they can generally get from bank accounts.

For floating-rate Treasuries, though, the real question is just how much of a premium they would command over simply owning and rolling over successive investments in short-term Treasury bills. With two-year Treasuries yielding just 0.25% and even five-year securities carrying yields well below 1%, it's hard to see a spread of more than half a percentage point or so unless the Treasury issues longer-term floating-rate notes. As a result, these securities are likely to look pretty unattractive even in comparison to low-yielding conventional Treasuries.

Still, with interest rate risk being the primary problem for Treasury investors, floating-rate bonds would resolve concerns about higher rates. Just as TIPS were slow to take off but eventually gained favor once investors got more familiar with them, so, too, might floating-rate Treasuries fill a need that will grow in the coming years.

Get smart
GE and other companies have offered floating-rate notes for a long time, but their best prospects may come from their stocks and their high dividend yields. Learn more about whether GE's stock is a better buy than its bonds by reading our premium research report on the industrial conglomerate, in which our industrials analyst breaks down GE's multiple businesses. You'll find reasons to buy or sell GE, and you'll receive continuing updates as major events unfold during the year. To get started, click here now.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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