Not Exactly Running for Cover

Economists love ‘em. The Treasury Department loves ‘em. But investors in the first auctions of inflation-indexed Treasury securities earlier this year probably would not use “love” to describe their feelings for the bonds.

Because their bonds’ prices have dropped sharply in market trading, initial investors are sitting on paper losses of about $25 per $1,000 bond. Had they purchased regular 10-year Treasury bonds instead of the inflation-protection kind, the investors would have a $19.10-per-bond paper profit.

Of course, investors who hold the bonds until maturity are not affected by market price fluctuations. But buy-and-hold investors of inflation-protected debt are also getting paid a lower interest rate than they would have gotten with regular 10-year treasuries.

Undaunted by the poor trading performance, the Treasury sold an additional $8 billion in the newfangled securities last week. It enticed investors by raising the stated coupon to 3.625% from 3.375% and cutting the maturity to five years from 10. (The 10-year notes were priced at 3.45% in January but are now trading at about 3.70%.)

Although some bond dealers were worried that investors still wouldn’t bite, Wednesday’s auction attracted more bids, both from institutions and individual buyers, than a previous one in April. Actually, it may be simply that some initial excitement about the new bonds translated into a higher-than-justified initial price for the first bonds in January.

“We view the development of the inflation-indexed market as a long-term process,” said Roger L. Anderson, deputy assistant Treasury secretary for federal finance. “Obviously, if investors are dissatisfied, that’s not the best advertising for us.”

Wall Street officials moan that few investors want these securities, adding that the brokerage house bond dealers lost a bundle on the two previous auctions of 10-year “tips,” traders’ lingo for the inflation-indexed securities.

William Dudley, chief U.S. economist at Goldman, Sachs & Co., said it’s far too early to declare tips a bust.

“There’s a lot of uncertainty, but this is how new markets get born,” he said.

So far, taxpayers are saving money, Dudley noted, because the Treasury has been able to sell $23 billion of the securities at a lower interest cost than it would have paid on regular bonds.

Although the idea of inflation protection appeals to many, several factors are working against the securities’ success. First, few investors are worried about inflation right now. Add to that the tax impact of the inflation adjustment, investors’ preoccupation with the stock market, uncertainty about potential changes in how inflation is calculated and the slowness with which pension funds and other institutional investors embrace a new product.

“If we get a spike in consumer prices, the perception of the value of these securities could change dramatically,” said Larry Dyer, a bond market strategist at Credit Suisse First Boston.

Tips are designed to protect investors from rising inflation, which erodes the future purchasing power of a dollar saved today.

Here’s how: The principal amount--meaning the amount of money the investor will get at maturity--of each $1,000 bond is adjusted based on the change in the urban consumer price index, which is calculated monthly by the Bureau of Labor Statistics. The Treasury makes twice-a-year interest payments to investors, equal to the stated coupon amount multiplied by the new principal amount and then divided by two.

Initial investors in the 10-year tips will get their first interest payment today of $17.06 per $1,000 bond. The principal amount will tick up to $1,010.85, based on the inflation-adjustment calculation.

Claude Amadeo, senior research associate at Bridgewater Associates, a Wilton, Conn., money management firm, said his firm purchased 10-year tips at the last auction as part of a portfolio of about $500 million in global inflation-indexed investments. He said heavy selling in the last few days by institutions that had lost money on the bonds had driven down tips’ prices so that they are starting to look attractive.

For other investors, though, tips have proved to be a hard sell.

If the Federal Reserve Board “does its job properly, inflation-protected securities are not a good place to have money,” Dudley said.