The US Treasury and Wall Street dealers are set to discuss whether to introduce a new debt security to help finance the country’s mounting budget deficit in the coming years.

Topping the agenda of a meeting on Friday between Treasury officials and dealers, who underwrite US government debt sales, is the possible introduction of floating-rate notes.

In contrast to normal fixed-rate Treasuries, which pay the same coupon throughout their lifespan, the payment to investors from floating-rate notes would go up or down as the Federal Reserve changed short-term interest rates. That could make them attractive to investors who think that Treasury yields have hit a floor and are set to rise in the coming years.

“We think the case for diversifying the Treasury’s funding sources by introducing [floating rate notes] is very strong in light of the prospect of persistently large budget deficits in the years ahead,” said Lou Crandall, economist at Wrightson Icap. “They would give the Treasury an additional tool for meeting unexpected increases in borrowing needs that would neither place upward pressure on long-term rates nor add to the government’s near-term rollover needs.”

But the discussions may not herald the imminent introduction of such securities. The Treasury has asked similar questions in the past and is conservative about changes to debt issuance. The last new Treasury issuance product it introduced was inflation-protected securities in the late 1990s.

According to the agenda for the meetings, the Treasury will ask dealers about the “optimal structure” for floating rate securities, how they “would affect Treasury’s overall cost of borrowing”, and whether there would be “robust market demand” for such debt.

“There would be demand for floating rate Treasuries,” said Rick Klingman, managing director at BNP Paribas. “From my perspective I would rather own floating-rate than fixed-rate debt over the coming years.”

With the prevailing view in the bond market that Treasury yields have set their lows and will gradually rise in the coming years, issuance of floating-rate debt could prove more costly for US taxpayers.

As it stands, the US Treasury is locking in funding over the next 30 years at record low yields. This month the sale of $13bn 30-year bonds came at a yield of 3.12 per cent – well below the 4.75 per cent level the issue was sold at in February.

Regular sales of floating rate notes would help meet the expected demand for safe securities to be placed on bank’s balance sheets under proposed tighter capital standards under Basel III and as collateral in derivatives trading.

“The need for safe, short-term dollar-denominated assets is likely to exceed the supply for as far as the eye can see,” says Mr Crandall.

One drawback for the Treasury is that it is intent on extending the average maturity of its debt from around its current age of 62 months. Should the Treasury sell three-year $20bn in floating-rate notes per month, the monthly rollover burden would reach that figure once the issues began maturing.

While the Treasury could sell longer-dated FRNs of up to 10 years, extending the maturity beyond three to five years may not attract investors who would be the target market for the product, says Mr Crandall.

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