Interest rates have been low for a long time. After so long, savers can hardly remember when they got any income worth mentioning from ordinary income-producing investments like bonds and bank CDs.

For most people, the prospect of locking in ridiculously low rates for several years just doesn't make sense. That may be one reason that the U.S. Treasury is looking into a new type of Treasury bond that would hold a lot more appeal for investors during this unprecedented period.

Going with the float
Reports came out recently that the Treasury is considering offering something it never has before: a floating-rate Treasury bond. The new offering could be available as soon as the second half of this year. With some estimates putting the volume of new floating-rate bonds at $10 billion per month, the idea would be to use the offering to take the place of short-term Treasury bill issues, helping the Treasury extend the average maturity of its issued bonds.

The Treasury wouldn't be the first to issue floating-rate bonds. Fannie Mae and Freddie Mac have made use of floating-rate issues before. Various corporations have also issued floating-rate bonds from time to time in order to get financing for various corporate purposes. But given the magnitude of the Treasury's need to raise cash, the relatively small floating-rate market could get a whole lot bigger in a hurry.

How would floating-rate bonds work?
The mechanics of a floating-rate bond offering would involve choosing a benchmark rate against which the bond would pay interest -- likely the prevailing three-month bill yield, although using the yields on the 10-year (INDEX: ^TNX) or 30-year (INDEX: ^TYX) bonds could also potentially work. An auction would establish the premium to add to that benchmark. So for instance, a bond might pay the three-month rate plus 0.1 percentage points, with the actual prevailing rate moving over time.

The bonds would address several concerns. First, they would give investors who are willing to lock up their money for an extended period an option that would avoid locking in record-low rates throughout that period.

But also, for money market mutual funds and other conservative investments that have struggled with Treasury-bill rates near zero, the new bonds would offer a slightly higher yield with just as much safety -- but no risk of capital losses due to rising rates. That in turn would help alleviate pressure on Fidelity, JPMorgan Chase (NYS: JPM) , and Federated Investors (NYS: FII) -- the three largest money market mutual fund managers -- along with Charles Schwab (NYS: SCHW) and others that have had to waive fees to keep yields from going negative.

Should you buy?
One downside of the floating-rate bonds for investors is that at least initially, the rates you'd get for a given maturity of bond would actually be less than you'd get from a conventional Treasury bond. Because the yield curve is currently very steep, it reflects expectations that rates will rise in the future, and those expectations would push down the premium you'd get over the short-term T-bill rate.

Another concern is that with any new security, accurate pricing can be difficult. For instance, when the Treasury introduced inflation-indexed bonds in 1997, they paid what turned out to be extremely high real rates of return. Only later did the market adjust to a lower equilibrium rate. Although that arguably worked in investors' favor with TIPS, there's no guarantee that it wouldn't go the other way with floating-rate bonds.

Still, the idea of a fixed-income security that doesn't have interest rate risk is exceedingly attractive in today's rate environment. For now, the best course of action is to wait and see exactly how floating-rate Treasury bonds get structured -- if they ever come to market at all.

Nearly every investor needs more than just bonds in his or her portfolio. For stocks that can fit the risk profile of any investor, please accept my invitation to read The Motley Fool's latest special report. Inside, you'll find three attractive stock ideas for long-term investors. The report is free -- but don't wait: Click here and read it today.

At the time this article was published Fool contributor Dan Caplinger swims OK but has a hard time just floating. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of JPMorgan Chase. Motley Fool newsletter services have recommended buying shares of Federated Investors and Charles Schwab. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy will keep you afloat.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.


Increase your money and finance knowledge from home

What is Short Selling?

Make a profit when stocks prices fall.

View Course »

Introduction to Preferred Shares

Learn the difference between preferred and common shares.

View Course »

Add a Comment

*0 / 3000 Character Maximum