The Money Market - Part 2: Nontraditional Instruments

Part 2: Nontraditional Instruments

Money market instruments are favored by investors who prefer short-term investment horizons. There are two types of these security instruments. In Part 1 of this series we saw the first category of money market investments: traditional instruments. This article will focus on another type of money market security: nontraditional instruments.

  • Floating Rate Notes (FRNs) - FRNs are corporate notes which pay an interest rate that “floats” (or fluctuates) in response to changing market interest rates. For instance, the interest rate that the note pays may change every six months. The date that the rate changes is known as the reset date. Since the rate rises and falls as market interest rates rise and fall, the market value of the note stays reasonably constant. The coupon rate (which is the interest rate stated on the note) is usually determined by a formula that’s tied to a widely-publicized index rate; the most commonly used indices are the LIBOR rate, the Prime rate, and the T-bill rate. The LIBOR rate (London Inter-Bank Offering Rate) is the rate at which banks in London lend money to each other. The Prime rate is the rate at which U.S. banks lend money to their largest and highest credit-rated clients. The T-bill rate is the rate at which the U.S. Government can borrow money.

    While most short-term interest rates move in tandem, the T-bill rate will often move in the opposite direction of other short-term rates. This happens because political and economic shocks usually result in investment activities which could be described as a “flight to quality”. In other words, during times of war, economic turmoil, or political uncertainty, investors tend to become more concerned about the credit quality of their investments. They therefore will rush to move their money from other short-term investments into T-bills. As a result, the price of T-bills will rise (with a corresponding yield fall), while the price of other instruments falls (making their yields rise). Since these rates move in opposite directions, the coupons on FRNs that are tied to these rates also move in opposite directions. Many investors choose to diversify their portfolios by buying FRNs tied to different indices. While it’s possibly to buy one FRN for about $1,000, most are purchased in amounts of $1 million or more.

  • Adjustable Rate Preferreds (ARPs) - ARPs are similar to FRNs in that the dividend rate (they are preferred stocks) which they pay floats in response to changing market interest rates. Their rates are usually tied to the highest of the 90-day T-bill, the 10-year Treasury note, or the 20-year Treasury bond rates. The highest of these rates is called the basis rate. ARPs are attractive as money market instruments because when a corporation buys another company’s preferred stock and holds it for at least 45 days, seventy percent of the dividends that the corporation receives is exempt from federal income tax. The major issuers of ARPs are banks, utilities, and insurance companies that want to match their assets against their liabilities.
  • Money Market Preferreds (MMPs) - Money market preferreds are preferred stock that are specifically designed to be money market instruments. They are auctioned every 49 days on a yield basis. They offer corporate investors the same tax advantage as ARPs.

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