Why Treasury Dept. May Place Its Money on Inflation-Indexed Bonds
Are you worried that inflation will ravage your future buying power?
The U.S. government is gambling that you are. In fact, it’s hoping that you’re so worried that you’ll be willing to sacrifice a little of today’s returns for tomorrow’s financial security.
The Treasury Department has begun gathering comments about its plan to issue hybrid 10- and 30-year IOUs, called inflation-indexed bonds. Either the interest rate or the principal value of these bonds will be adjusted to reflect the rise in the cost of living during the tenure of the bond. In addition, investors will earn a modest return over the inflation rate--possibly between 3% and 3.5%.
In a series of meetings around the country and in public appearances, department officials are discussing the form the bonds will take, how frequently the inflation adjustments will take place, what inflation index will be used or precisely how much of a “real”--inflation-adjusted--return will be paid.
On Wednesday, at the first such meeting, Darcy Bradbury, assistant Treasury secretary for financial markets, said the Treasury probably will sell inflation-adjusted government securities four times a year, with the first sale likely in the fall.
The new securities will be multiyear, she said. There would be little need for short-maturity inflation-indexed bonds, because inflation poses less of a threat to investors over brief periods.
“Our initial thought is it would be better to issue these--in a sense matched with our current regular bonds,” she said.
Selling inflation-indexed securities with the same maturity, and at about the same time as Treasury securities that aren’t indexed to inflation, would give investors and traders an opportunity to profit on the difference in the yields of the two types of securities, a potentially risky process called arbitrage. Such a market would focus attention on inflation expectations and would help the Federal Reserve Board in setting monetary policy as it fights inflation.
Overall, Uncle Sam would prefer to leave the details to you. A key reason the Treasury is anxious to find out what bond buyers think--particularly those in the U.S. and Japan--is that the handful of other countries issuing inflation-indexed bonds haven’t been overwhelmed by demand.
In Canada, for example, this type of bond has been available since 1991. The Canadian government, which has $250 billion in debt outstanding, has issued about $5.8 billion in inflation-indexed debt--just about 2% of the total.
“We would like to increase issuance of the product over time. That is definitely our objective,” says a Canadian government official who asked not to be named. “But the amount we have issued so far is based on what the market will bear.”
In Britain, inflation-indexed bonds also account for a small amount of total bonds outstanding, and, as in Canada, the retail market for these bonds is slim. In fact, it seems the only enthusiastic buyers of inflation-indexed bonds are defined-benefit pension plans, which find them valuable because of the way pension payouts are structured.
However, many financial experts agree that this type of bond could be a valuable--albeit small--component in nearly every long-term portfolio. The reason? One important aspect of every long-term savings plan is the retention of buying power. If the cost of living--or rate of inflation--exceeds the rate of return on your savings, you actually lose buying power with every dollar you save. And whereas investments in stocks and bonds tend to beat the rate of inflation over time--and thus increase your future buying power--they offer no guarantees. For that reason alone, many financial planners work “inflation-hedging” investments into consumer portfolios.
Established inflation hedges--ranging from precious metals to real estate--are far from perfect. While some argue that they do pace the rate of inflation over time, whether they work for or against you largely depends on when you bought them.
In 1977, gold sold for $165.60 an ounce. If you happened to buy at that price and sold out at the end of 1994 for $382.50 an ounce--the going price--you would have earned a 4.7% average annual return, which largely mirrors the inflation rate over the period. But if you bought at the end of 1980, at the going price of $589.50, you would have lost money in both real and relative terms. Real estate has registered the same inconsistent history--up strongly one year, down dramatically the next--sometimes in direct opposition to movements in the cost of living.
So bonds that are guaranteed by the federal government to track and exceed the inflation rate can be a real benefit. Why, then, have they proved such wallflowers?
Probably because the rate of inflation is low--and has been for nearly a decade. Over the last dozen years, U.S. inflation has averaged 3.5%; in Canada, it’s been even lower. That means investors who buy inflation-protected bonds earn a lackluster current return. And it’s tough to convince investors that a bond yielding 6% today might eventually be more valuable than one yielding even 6.5%.
How important is inflation anyway? Naturally, the answer depends on the inflation rate and the time frame. But assuming a 3% annual rate--U.S. inflation has averaged 3.13% annually since 1926, according to Ibbotson Associates, a Chicago-based research firm--a $1,000 savings account would buy you the equivalent of $549 worth of goods 20 years from now. In 30 years, you’d get just $407 in goods. In other words, even modest inflation can put a serious dent in your buying power over time.
Still, ideally investors want their savings to generate returns that exceed inflation, not track it. So the inflation-hedging portion of your portfolio ought to be a relatively small fraction of the total. Experts variously suggest between 5% and 25% of your total investments, depending on your age, time horizon and ability to tolerate risk.
But here’s the tricky part. Just exactly how would you like your inflation hedge to be structured? Do you want a zero-coupon bond--something like a U.S. Savings Bond--that’s sold for a fraction of its face value and pays all interest and principal when it’s cashed in? Or would you prefer an investment that generates current income? How much of a real return would you demand on this type of investment?
While you’re at it, why not ponder exactly what inflation index you’d like your bond to be tied to. The Treasury Department is considering four--two slightly different measurements of the consumer price index, a wage inflation index and an economic index called the gross domestic product deflator.
The GDP deflator is believed to be among the more accurate inflation measures, but the wage inflation index would keep investment returns up with your wages rather than a generic gauge of prices.
In any event, the Treasury says the evidence is strong that it will save money with inflation-indexed securities because investors will accept a lower interest rate in return for inflation protection.
Those who wish to attend Treasury meetings should call the Bureau of Public Debt ([202] 219-3350) near the meeting date to find out what time the meetings start. The California meeting will be held June 6 at the Federal Reserve Bank of San Francisco, 101 Market St.
Bloomberg Business News contributed to this column.
Kathy M. Kristof welcomes your comments and suggestions for columns but regrets that she cannot respond individually to letters and phone calls. Write to Personal Finance, Business News, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053, or e-mail kathy.kristof@latimes.com
