New Derivative Instrument – US Treasury Bonds?

In two previous columns, I explained how US Treasury Bonds work and why with looming inflationary concerns, why they are essentially worthless. Don’t get me wrong, fixed-rate Treasuries are as popular as they’ve ever been as the world’s wealthiest investors work to keep their Sugar-Daddy as liquid as possible. The problem is that while investors are keeping Uncle Sam in a liquid position, they’re losing money on low yields and rising inflation! Treasury Inflation Protected Securities (TIPS) can provide some protection against inflation, but these tend to pay negative yields so investors are still losing money. An investor can seek higher yields with European debt, but the risk of default is so high that they’re more likely just throwing their money away.

Ever the innovator of financial instruments, the US Treasury Department has proposed the creation of a new bond product designed to make investing in US Debt sexy again.

US Floating Rate Note

This is how it would work, which reflects the genius in its simplicity. Unlike TIPS, which adjusts the bond’s Book Value in accordance to changes in the CPI, the Floating Rate Note will adjust its Coupon Rate based on the current Benchmark Rate. The rate would adjust every six months (just in time for its semi-annual interest payment). That way, if inflation suddenly goes up, investors can be confident that even though their present value of their investment is going down, at least their interest payments will be able to keep up.

Most investment analysts believe that once this new product is introduced into the bond market, investors will snap them up as a hedge against inflation that is supposedly guaranteed to pay upon maturity and has “zero” chance of default.

Macroeconomic Implications

The introduction of this new security type basically means that the US Government is getting into the Derivatives Market. A derivative is basically any investment instrument with a built-in hedge element. TIPS were a step into that market, but Floating Rate Notes takes the Government all the way in.

The subtext of this offering is that the Government is letting all of its biggest investors know that hyperinflation is on its way and they want them to keep on investing in US Debt even when it is beyond clear that doing so will lose them millions of dollars. After all, the government needs to keep its investors solvent if it has any hope of keeping itself solvent.

In the meantime, the government will continue to run up a higher debt level, the Fed will continue to pump more fiat money into the money supply, and investors will continue to pretend that all of this is normal, and just another day at the office.

That is, until the day it all blows up in their faces, and then we’ll look back and wonder how we could have been so stupid!

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