Treasury Inflation-Protected Securities
A new age dawned in the U.S. capital markets on Wednesday, January 29, 1997. The United States Treasury made its first issue of an inflation-linked bond, the 3.375% of 2007. This bond increases its principal by the changes in the Consumer Price Index (CPI). Its interest payment is calculated on the inflated principal, which is eventually repaid at maturity. This gives an investor the ability to protect against inflation while providing a certain “real” return over an investment horizon. Despite critics and uncertainty over the “great inflation debate”, the auction went extremely well with interest five times the size of the $7.0 billion issue. The “real yield” of the TIP reached more than 3.5% in the “when issue” trading before the auction but fell dramatically to 3.3% in the aftermarket trading.
It’s the “Real” Thing
The issue of the TIP is a major development in the U.S. capital markets. For the first time, investors will be able to achieve a certain “real return” above inflation over their investment period. A normal or “nominal” bond pays its interest on a fixed principal amount, which is repaid at maturity. Inflation is a major risk to a nominal bond holder, since increasing inflation means reduced “purchasing power” is in the face of increasing prices.
A good example of a TIPS investor would be an individual setting aside retirement funds in an IRA. Purchasing a $100,000 TIPS would lock in this amount in real terms. Whatever the inflation rate until the eventual retirement, the $100,000 would be completely “indexed” or have its value increased to offset any increases in inflation.
The Naked Bond?
The TIPS issue used the structure of the Canadian inflation-linked program, which allows for “stripping” or the creation of “zero coupon” bonds. This separates the coupon payments or “coupons” from the principal amount or “residual”. While this has been done for years with nominal bonds, it promises a new capability for investors. Using the “real zeroes”, an investor could place an amount in a specific term and ensure an inflation-proof result. For example, an insurance company wishing to set funds aside to pay claims linked to inflation could purchase the exact amount of “real zeroes” to cover the claim in today’s dollars. No matter what the intervening inflation, the amount invested would grow to exactly equal the amount required to settle the claim.
How Good is a “Real” Thing
The value of the inflation protection of the TIPS is being hotly debated in investment circles. To simplify the arguments, we can compare the yield available on a normal or “nominal” 10-year Treasury Bond to the TIP. At current yields, a nominal 10-year Treasury yields 6.4%. If we subtract inflation, currently 3.3% for the CPI, we get a “real yield” of 3.1% (6.4 – 3.3 = 3.1). The current yield of the TIPS is 3.3% “real”. This means that the real yield of the TIPS is .2% higher than the same term nominal Treasury. We can think of it another way. Add 3.3% inflation to the TIPS yield of 3.3% and we have a total yield of 6.6%, which exceeds the nominal treasury yield of 6.4%. Given that the TIPS is inflation-risk free, this doesn’t make a lot of sense. We receive more interest for an inflation-protected bond than a normal risk bond!
The reasons for this are threefold:
First, with any new investment, especially in the conservative bond market, the first issues come “cheap”, or inexpensive relative to standard “plain vanilla” issues, which attracts investors and compensates for the new nature of the security.
The second reason is the smaller size of the TIPS market, which makes it “illiquid” or harder to trade than the huge existing Treasury market. Given the $7 billion size of the initial TIPS issue, this might come as a surprise, but this is small change compared to the hundreds of billions of existing Treasury bonds.
The third and perhaps the most important reason is the uncertainty over the status of the current CPI index. Many politicians, government officials and even Alan Greenspan, the Federal Reserve Chairman, are of the belief that the current CPI, as calculated by the Bureau of Labour Statistics (BLS), is overstated.
The Great Inflation Debate
Conveniently, a lowering of the CPI would help to balance the budget and this is the political incentive. The widespread and vocal discussion has created much uncertainty in the marketplace about TIPS, since its principal is increased by the published CPI. The thesis that the CPI is overstated by .5% to 1.5% has led to a much higher yield on the TIPS than would probably otherwise be the case. Not a smart move by the government and those involved, but whoever said that politicians were smart? The arguments for and against the CPI’s accuracy are being mustered but in any event, the eventual resolution will be well into the future. So far we’ve only heard one side of the story and the other will soon come out. Any restatement will take time and research. This could provide some shorter-term value to prescient investors.
Other Countries Have Been Doing It
The United Kingdom has issued “Inflation-linked Gilts” (ILGs) since 1981 and has a variety of different terms of issues. Canada issued the 4.25% of 2021 “Real Return Bond” (RRBs) in 1991 and has reopened this issue many times since. Canada added a second issue, the 4.25% of 2026 in 1996. Sweden, Australia and New Zealand also issue inflation-linked bonds.
The Time to Buy Insurance is When You Don’t Need It!
As the old saying goes: “the time to buy insurance is when you don’t need it”. This holds true for the TIPS as well. Inflation, remarkably under control for the past five years at 3% plus or minus a bit, is the biggest anger a fixed income investor faces. The fact that most bond managers, and investors, can’t conceive of generally higher inflation means that it is not factored into the price of current bonds. Compared to the savaged bond investors of the 1970s, who called bonds “certificates of confiscation”, the current crop of bond managers is diving into 100-year securities and fretting about upcoming bond shortages. Almost twenty years of declining interest rates and inflation has made wary bond managers an extinct species.