	Background

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. 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

		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

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. 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. Mismatch Between the FRN’s Index Rate Maturity and Reset Frequency Poses Risk That Treasury Has Not Fully Analyzed

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. 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. increase the maturity profile of the debt portfolio while meeting high  demand for high-quality, short-term securities. 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. 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. 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). Our survey results suggest demand for Treasury FRNs is likely to grow. Overall, market participants felt prepared for the introduction of a new  security. 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. Survey Respondents Reported Interest Both in FRNs with Different Maturities and Other New Types of Treasury Securities

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). 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. FRNs can also help enhance Treasury flexibility by marginally  increasing demand for Treasury 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. 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. 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. When deciding  what to issue, Treasury must make prudent decisions about investor  demand by product. Analyze the price effects of the mismatch between the term of the  index rate and the reset period;  2. 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. 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. Appendix II: Survey Scope and Methodology

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. Results of the survey are not generalizable.
Why GAO Did This Study

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 .)

What GAO Found

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.

What GAO Recommends

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.