Bonds Away: Treasury Blasts Inflation Risk

By Coons, James W. | ABA Banking Journal, December 1996 | Go to article overview

Bonds Away: Treasury Blasts Inflation Risk


Coons, James W., ABA Banking Journal


The issuance of inflation-indexed U.S. Treasury bonds will create tools for managing interest rate and inflation risk and could lower government borrowing costs. Investors might be able to target higher returns without taking greater risk by adding indexed bonds to their portfolios. In conjunction with traditional bonds, the new securities will generate useful information for monetary policymakers.

The Treasury will begin a series of quarterly auctions of 10-year notes in January. The principal will be adjusted every six months by the percent change in the seasonally unadjusted consumer price index (CPI) during the six month period ending three months earlier. The semi-annual interest payments will be determined by multiplying the fixed coupon yield and the adjusted principal. Both interest payments and additions to principal will be taxed as interest income. Treasury officials plan to offer indexed bonds at maturities of 2 years, 5 years, and 30 years by the end of 1997.

The yields on traditional, or nominal, Treasury bonds include four components. The real rate is the return on the principal. The inflation-expectations premium offsets the erosion in the purchasing power of the principal from anticipated inflation. An inflation-risk premium insures against higher-than-expected inflation. A liquidity premium compensates for transactions costs.

The Treasury can save money with indexed bonds in two ways. First, if inflation is lower than expected, interest costs will be less than for nominal bonds. The reason is investors will receive compensation only for the smaller reduction in purchasing power that actually occurs.

An increase in inflation would push the cost of inflation-indexed bonds above that of nominal bonds. Deflation would not save money because the indexed bonds will be redeemed for no less than the nominal amount of the initial investment. (However, the principal would be adjusted downward in the event of a decrease in the CPI for the purpose of calculating interest payments.)

Second, inflation-indexed bonds can lower borrowing costs by cutting out the inflation middleman. In return for protection from higher-than-expected inflation, investors will not demand an inflation-risk premium. That translates into an estimated 50 basis point reduction in borrowing costs. The savings will be higher if the bonds are purchased mainly by inflation-averse investors.

An important caveat is that a small or mismanaged program could outweigh the benefit from eliminating the inflation-risk premium by raising the liquidity premium. …

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