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Inflation Bonds

 

U.S. Treasury Issues Inflation Bonds

News

On January 29, the U.S. Treasury's first-ever offering of debt designed to protect investors from inflation was a huge hit as buyers placed bids for $37.2 billion of the securities--five times the amount offered. The $7 billion of 10-year inflation-indexed notes were auctioned at an annualized fixed yield of 3.449%, which by the end of trading the yield was down to 3.38%.

The 10-year "inflation-indexed" bonds are formally called Treasury Inflation Protection Securities, or TIPS.

The fixed annual yield on standard 10-year Treasury notes currently is 6.62%.

Analysis:
I would like to take this opportunity to answer the following points:

  1. The relationship between the return on such bonds and bonds in general.
  2. What is the government's motivation for issuing them?
  3. Who will buy them?
  4. Why now?
  5. Is the Yield to Maturity (YTM) a good measure of the yield on such bonds?
  6. How do you measure inflation?

The Relationship Between The Return On Such Bonds And Bonds In General.

You should distinguish between two types of yields (i.e., rates of return): coupon rate vs. the market-determined yield on the bond, i.e., the yield to maturity (YTM). The coupon rate, set when the bonds are issued, determines the fixed cash-flows to be received by the investor over the life of the bond, while the YTM represents the opportunity cost, also referred to as the rate of required or expected rate of return.

Thus,

price of the bond =  coupon x PVIFA( n, YTM) + face value x PVIF(n,
YTM)

where,
     coupon         = coupon rate x face value
     PVIFA          = present value of interest factor of an annuity
               = present value of $1 annuity
     PVIF           = present value of interest rate factor
               = present value of $1 to be received on period "n" in the
future.
     n         = the number of periods over which the bond is paid
     YTM       = yield to maturity
     face value     = $1,000

What factors influence the YTM?

The YTM is compensation to the bond investors for assuming the sources of risk inherent in the bond. This compensation is for:

  1. Pure "time value of money," that is, for tying up your money in a risk-free investment; denote this compensation by "RF."
  2. Uncertain future inflation; call the associated compensation "IP."
  3. Liquidity of the asset; the longer you need to wait to sell an asset, the lower the liquidity, and thus, the higher the compensation; call it "LP"
  4. The longer the maturity of the bond, the higher the compensation; call it "MP".
  5. The possibility of not getting paid, i.e., default risk. Call it "DP."

Thus,

  • YTM = RF + IP + LP + MP + DP (*)

In the case of a government bond, the DP is zero.

What Is The Government's Motivation For Issuing Them?

The government's proposal is to make the coupon rate fluctuate with inflation. This type of cash-flow arrangement is analogous to an adjustable rate mortgage. So what should such a feature do to the price of bonds?

It should, other things being equal, reduce the uncertainty associated with future inflation that investors face. But a lower uncertainty means a lower IP. Thus, the YTM should be lower. Hence, when the government issues these bonds, investors will require a lower financing rate than a similar bond which does not have such an inflation protection feature. Obviously, the lower financing charge should save the government some money and lower its deficit.

The above feature alone, however, does not guarantee a lower YTM for a given maturity date. The reason is the liquidity of these bonds. In general, U.S. Treasury bonds are very liquid and thus the associated LP is zero. Since these bonds are new, and if investors use them as a retirement investment vehicle (see below), then there might not be enough demand or supply for these bonds all the time. If this turns out to be the case, then investors are going to require a higher LP, driving the YTM up. The government is very aware of this fact, and this issue will be a factor in determining the amount to be issued.

Who Will Buy Them?

The government is targeting it as a new investment vehicle for retirement. Investors who are worried about inflation eroding the value of their investment will have a way to protect bond values against inflation.

Remember, if inflation increases, or if it is expected to increase, then IP increases, leading to a higher YTM. But YTM and bond prices are inversely related; that is, when YTM increases the price of the bond goes down. So how will these bonds protect the investor?

The coupon rate, which determines the size of the periodic cash-flows paid to the bond holders, is not fixed; it is tied to the inflation rate. So when the YTM increases as a result of an increase in inflation, so do the cash flows, thus offsetting each other and leaving the price of the bond unaffected by changes in inflation.

For now, few investors can put such securities into 401(k) retirement accounts which restrict investors' options to a menu that changes infrequently. However, but both Dreyfus and the Benham group of American Century have announced plans for mutual funds that will buy these securities.

Why Now?

As noted above, the liquidity of such bonds is crucial in securing low cost financing for the government. The rapid growth in 401(k) retirement plans increases the chances of success for such an endeavor. The government is betting that some mutual funds will be investing in these bonds, thus offering individuals an affordable opportunity to indirectly purchase these bonds with small investments of, say, $100.

Is The Yield To Maturity (YTM) A Good Measure Of The Yield On Such Bonds?

The YTM is that particular discount rate that equates the present value of a bond's cash-flows with its market price. Thus, it is a rate of return that is implied by the market price of the bond at any given point in time. The drawback of such a measure of return is that it implicitly assumes that yields are equal over the life of the bond as you are calculating one discount rate for the life of the bond. This problem is not unique to the type of bonds we are considering here, but it makes the constant discount rate assumption even less convincing.

How To Measure Inflation?

The most widely used measure of inflation is the Consumer Price Index (CPI) which represents the price of a basket of consumer goods. Another measure is the Producers Price Index (PPI). Recently, however, some economists have cautioned against using the CPI as it overstates inflation. Thus, this will be another issue that the Treasury needs to resolve when it puts all the details together.

Q&A
According to the WSJ (January 30, 1997), most observers had predicted that the Treasury would have to provide a yield of about 3.5% to entice investors.

What Is The Inflationary Premium?

Assuming LP = 0, then IP = 6.62% - 3.50% = 3.1%

Some Facts About These Bonds
While they will be sold in initial amounts of $1,000, as with other Treasury notes and bonds, that principal amount will be adjusted daily, based on changes in the Consumer Price Index (CPI) three months earlier.

Example:

Here's an example how the bonds might work:

Say you buy one bond at $1,000 when inflation is 3%.

To get the new principal, multiply $1,000 by the inflation index of 3%, then divide the product ($30) by two to get the amount for each six-month period. Add that amount, $15, to the $1,000 principal to obtain $1,015. For the interest payment, multiply the new principal, $1,015, by the coupon rate of 3.75% and divide by two to get the amount for each six-month period. Thus, the principal value of the indexed bond after six months would be $1,015, and the first interest payment would be $19.03.

If inflation remains at 3 percent, the 12-month principal would rise to $1,030.23, and the second interest payment would increase to $19.32.

Tax implications
Just like other Treasury securities, the bonds are exempt from state and local income taxes. The interest that has been paid and the rise in the principal value, even though the cash from that increase will not come in for years, are subject to federal taxes in the year received . As a result, these bonds are probably better suited for tax-deferred retirement accounts.

Where It's At In Text (Basic Financial Management)?
Chapter 2: The Role of Financial Markets and Interest Rates in Financial Management
Page 61-68: Interest Rates and Real Rate of Interest

Chapter 7: Bond Valuation
Pages 267-268: Bond Valuation: First Relationship

What It's All About?
nominal rate of interest (page 66)
real rate of interest (page 67)
interest-rate risk (page 268)

Government Resources

The Bureau of the Public Debt: For a summary of inflation-indexed Treasury bonds

The San Francisco Federal Reserve Bank:
(415) 974-2330 or write to the bank, attention: Treasury Direct, at P.O. Box 7702, San Francisco, Calif. 94120.

U.S. Treasury Department or call (202) 622-2040.

key words: inflation-indexed bonds, CPI, real vs. nominal interest rates, inflation

Sources: LA Times (January 29 and 30, 1997), San Francisco Chronicle (January 28, 1997)

 

By Alex Tajirian


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