Inflation-Indexed Bonds: The Dog That Didn't Bark
Kopcke, Richard W., Kimball, Ralph C., New England Economic Review
The introduction by the U.S. Treasury of inflation-indexed notes was one of the most widely publicized innovations in the U.S. capital markets in recent years. Since their introduction in January 1997, $57 billion in 5-, 10-, and 30-year Treasury Inflation-Protected Securities (TIPS) has been issued, and the Treasury has recently announced that TIPS will also be offered as small-denomination savings bonds. Because both the coupon and the principal of TIPS vary with the consumer price index, the Treasury believes these notes will appeal to risk-averse investors seeking protection from inflation. Proponents of TIPS have argued that their issuance should reduce the cost of borrowing to the Treasury by eliminating the risk premium associated with uncertain inflation; they also point out that the difference between the yields on TIPS and conventional Treasuries of the same maturity would provide an immediate, easily available, and clear measure of investors' forecasts of inflation.
Despite their promise, the demand for TIPS has not yet been very great. In the United States, these notes account for less than 2 percent of the marketable federal government debt outstanding. In the 5-, 10-, and 30-year maturities in which they have been issued, TIPS accounted for only 13 percent of new issues during the period from January 1997 through June 1998.(1) The three mutual funds devoted to TIPS held a total of only $30 million as of July 1998. This modest demand for TIPS is similar to that in other industrialized countries experiencing low or moderate inflation. In the United Kingdom, which has offered tax-sheltered inflation-indexed bonds since 1982, these bonds equal 12 percent of the outstanding public debt.
This article analyzes inflation-indexed bonds in general and TIPS in particular to better understand their modest appeal to investors. The first section discusses the experience of other countries with inflation-indexed debt, and the second reviews the design of the Treasury's TIPS. The third section compares the returns and risks of TIPS to conventional bonds, using a model that also weighs the consequences of taxes and various risk premiums. The model indicates that TIPS should appeal primarily to risk-averse investors in high tax brackets, investors who are especially wary of rising inflation, and investors who are not especially concerned about fluctuations in the real rate of return. The fourth section simulates the potential risk and return characteristics of TIPS using data from the past 13 years and finds that TIPS often can be dominated by more attractive combinations of other securities. In particular, a suitable combination of stocks and conventional bonds offers savers a greater, albeit potentially riskier, real rate of return than TIPS. Despite their unique design, TIPS are not alone in offering investors inflation-protected returns, so their appeal is limited for investors accustomed to holding diversified portfolios of securities.
I. Indexed Bonds
Today, the most common form of debt in developed countries is the conventional bond, a contract that obligates borrowers to repay their creditors a certain amount of their country's currency over the life of the contract according to a specific schedule. Since the inception of lending, however, some debt contracts have taken the form of indexed bonds, whose payments vary according to the value of a commodity, currency, or security. Indexed bonds tend to have been most popular when the purchasing power of a country's currency has been most unstable or unpredictable. Borrowers and lenders also have agreed to index their contracts when they wished to hedge specific risks.
In principle, indexed bonds would seem to dominate conventional bonds. Even in countries with a history of stable currencies and comparatively constant relative prices among goods and services, indexed debt may offer its parties a greater degree of security than conventional bonds. …