The U.S. Treasury's Inflation-Protected Securities : market reactions and policy effects - TIPS

Business Economics, Jan, 1998 by Albert E. DePrince, Jr., William F. Ford

This paper reviews the U.S. Treasury's new series of TIPS and their role in financing federal deficits and the national debt. After describing TIPS and reviewing the early evidence of institutional and individual investor responses to them, the emerging secondary market for TIPS and the derivative products that will flow from them are analyzed. The final section examines the long-term impacts of TIPS on monetary policy and federal deficit financing. While TIPS have been heralded as a disincentive to government-financed inflation, they have the unfortunate side effect of allowing the present government to push a large and growing burden of debt service payments onto future administrations.

After years of study, the U.S. Treasury finally auctioned its first tranche of inflation-protected securities on January 29, 1997. Patterned on the Canadian government's Real Return Bonds or RRBs [Circular], the new U.S. securities are popularly known as "TIPS," the acronym for Treasury Inflation-Protected Securities(1).

Like most of the dozen nations [BOE] that now offer inflation-indexed securities, U.S. TIPS protect investors against inflation by guaranteeing that a real coupon rate will be paid over the life of these securities. That is accomplished in two ways:

1. The principal amount that buyers initially invest in TIPS is adjusted quarterly, on a lagged basis, using the U.S. Consumer Price Index (CPI). At maturity, the buyers receive an accreted principal repayment that reflects the inflated value of their initial investment.

2. In addition, the semiannual coupons paid on TIPS are also adjusted for inflation by applying the note's stated "real" coupon rate to the inflation-adjusted principal amount as of the coupon date. [Abunboff et. al; Fiscal; DePrince and Ford](2).

Unfortunately, investors are currently taxed by the IRS on both the semiannual interest payments they receive and the yearly accretions to principal that they do not receive until their TIPS mature. The yearly accretion to principal is considered an "original issue discount" (OID) and treated as interest income for tax purposes [Treasury]. This treatment of the accreted TIP principal is the same as the tax treatment of the accreted value of zero-coupon securities. Unfortunately, this tax feature makes TIPS attractive mainly to investors who can hold them in tax-deferred accounts such as IRAs, Keoghs, 401Ks and other qualified pension plans. Indeed, this was identified as the main target market when Treasury Secretary Rubin indicated in May 1996 that the issuance of TIPS was imminent [Wilke].

As of October 1997, the U.S. Treasury had auctioned a total of $31 billion in TIPS. That amounts to well over 0.5 percent of marketable U.S. national debt. The first two tranches were issued in January and April with ten-year maturities and raised $7 and $8 billion, respectively. The third tranche, marketed in July, was a five-year note that raised $8 billion, with another $8 billion in October.

The Treasury has also announced that thirty-year inflation-indexed bonds will be issued periodically, beginning in 1998. The first tranche will likely be auctioned in early January 1998, with the second tranche in early April. The size is less certain. If two tranches are used, $7-$8 billion is likely for each, if the Treasury's current TIPS volume is replicated. But it is more likely that the auctions of the thirty-year TIPS will be smaller because such a large volume of thirty-year bonds could produce market congestion and a high auction yield. To avoid that, the Treasury may scale the auction of the TIP bonds back to, say, $5-7 billion.

The year 1998 also will likely see additional auctions of five and ten-year TIP notes, and the Treasury probably will seek to raise $35-$45 billion in TIPS next year from some combination of five-, ten and thirty-year maturities if the U.K.'s approach is a guide. U.K. TIPS (inflation-indexed gilts) now account for 20 percent of all new debt issued (i.e., both debt for the current deficit and the scheduled rollover of old debt) [HMT (3)]. Next year, the U.S Treasury will roll over $564 billion in marketable coupon securities. Ignoring, for the moment, the size and funding composition of FY 1997-98's deficit, a $45 billion target for TIPS auctions would be less than 10 percent of all coupon issues auctioned in 1998. This raises the possibility of a larger TIPS volume next year.

MARKET REACTIONS TO U.S. TIPS

The first tranche of U.S. TIPS, the $8 billion of tern-year notes auctioned on January 29, 1997, was well received. Bidders oversubscribed the issue by almost a 5-to-1 ratio, versus the normal 2-to-1 bid ratio for conventional ten-year notes. However, their auction-determined real yield of 3.45 percent was considerably higher than many market observers had expected. Also, less than $150 million of the notes were bid on a noncompetitive basis, indicating that initial individual investor interest in TIPS was weak. Since then, institutional investor interest has subsided, with the April TIP note auction posting only a slightly higher coverage ratio than the 2 to 1 typical for a ten-year note. Interest in the five-year TIP note (auctioned in early July) was also considered cool [Zuckerman (2)]. Interest in the October auction of five-year TIPS was a bit stronger. However, that interest was likely motivated by Chairman Greenspan's warnings on inflation just prior to the auction's close [Zuckerman (3)]. Had inflation warnings not been raised, it is likely that the October issue would have been no more impressive than July's.