U.S. to Offer Low-Risk, Inflation-Indexed Bonds

Seeking to help risk-averse investors save for retirement and other long-term goals, the Treasury Department announced Thursday that it plans to issue bonds that protect against inflation.

Treasury Secretary Robert E. Rubin said the inflation-indexed bonds--the first such securities ever issued by the federal government--could boost Americans’ relatively low savings rate while also reducing the government’s cost of financing its huge budget deficit.

The bonds would have returns linked to inflation so their value will not erode with rises in the cost of living over time. Current Treasury securities and other bonds can lose substantial value if inflation rises--scaring away many conservative investors.

The government also said it expects to issue the bonds in denominations as low as $1,000, to further appeal to conservative investors.

“We think the kinds of investors who will be most interested in these securities will be individual Americans saving for their retirement or for other long-term purposes, including their children’s education,” Rubin said.

However, market experts said it is too early to evaluate the bonds’ eventual popularity or value because the Treasury has yet to work out many details on how the new securities will be structured. Also, some experts questioned whether the government will save money, suggesting that a burst in inflation could boost Uncle Sam’s costs.

Also, because the bonds presumably will carry less risk, they also may carry a relatively lower yield--which could turn off some investors.

Treasury officials say they will be holding public meetings in a number of major cities, including San Francisco, New York, Chicago, Boston, Tokyo and London, to explain how the bonds might work and to get investor feedback.

Only after these meetings are concluded in June will the government make final decisions on some of the key elements, such as which inflation index to use in adjusting the bonds, and whether the interest rate will fluctuate or the inflation adjustment will be paid in a lump sum when the bonds mature. Nevertheless, Treasury officials said they expect the bonds to be launched sometime this year.

“We are approaching this pretty vigorously,” said Darcy Bradbury, Treasury assistant secretary for financial markets. “We haven’t announced a date yet, but we expect to do it this year. We are prepared to do it this year. But we want to make sure we do it right. That’s our first priority.”

Several important details about the bonds still must be determined. For instance, the return on the bonds might be tied to an inflation gauge. Four are currently being considered--the core consumer price index, the urban consumer price index, the employment cost index or the gross domestic product deflator.

Until the index is chosen, the government also can’t say how frequently the return on the bonds might be adjusted, because the CPI is calculated monthly while the employment index is calculated once every three months.

In addition, Treasury officials are weighing several different structures for the bonds. They could be issued as zero-coupon bonds--the same way that U.S. savings bonds are now sold--where the bonds are sold at a discount of their face value and then mature when enough interest accumulates to pay the full face amount. (A $50 savings bond is typically sold for $25. Its maturity date--the point it can be redeemed for $50--is determined by market interest rates.) Investors get their principal and interest back in one lump sum, when they redeem the bond at maturity.

Alternatively, the new securities could take the form of traditional Treasury notes and bonds, which pay periodic interest and are sold and redeemed based on their face value. Or they could be structured as a combination of both. In this scenario, investors would get periodic interest payments based on a set interest rate, but the redemption value of the bond would also increase based on the actual rate of inflation.

In any event, many experts believe the bonds could have an appeal to investors who worry about how inflation might affect the future value of their savings. These bonds would guarantee a “real” inflation-adjusted return no matter which way the cost of living goes.

“It reduces the risk that your real return is going to be squeezed by a sudden run-up in inflation,” says Gary Schlossberg, senior economist with Wells Fargo Bank.

It also would allow investors to buy bonds without having to worry about whether the value of their investment would be savaged by a rise in interest rates. Interest rates, which tend to increase whenever inflation threatens to rise, can savage bond values--as has been the case in recent months. The market value of a 30-year bond, for example, tends to fall 12.6% for every 1 percentage point that market interest rates rise.

While those who buy individual Treasury bonds and hold them to maturity are unaffected by day-to-day swings in the market price, investors who put their money in mutual funds that invest in bonds, or who need to sell their bonds before maturity, have suffered steep losses in the past several years when interest rates rose sharply.

Because the return on these bonds would vary based on the inflation rate, the value of their principal is less likely to swing sharply with changes in interest rates, says Dave Ballantine, head of the trading desk at Los Angeles investment house of Payden & Rygel.

* INVESTOR CHOICES: Will the new inflation-indexed bonds make sense for you? D1