A bond, a new bond.

• Author: Finney, Louis D.
• Position: Inflation-indexed bond offered by the Treasury Dept.

The Treasury Department's new inflation-indexed bond will react to changes in interest rates in novel ways. Corporate investors are wondering how it will fit into their portfolios.

On January 15, 1997, the Treasury Department will auction its first ever inflation-indexed bond. The idea of an inflation-indexed bond, or IIB, isn't new - several countries have been issuing them for years - and you can trace variations of it back to the 18th century. But the Treasury's decision to issue these bonds is significant because they represent a totally new type of fixed-income security that investors should find beneficial over the long run.

The general mechanics of the Treasury's inflation-indexed bond are quite different than those of a conventional Treasury bond, but straightforward. (See the table on page 30.) At the auction, a yield on the bond will be determined. Many will call this the real yield or real rate of interest, because it represents the guarantee of interest after the effects of inflation are included. For each subsequent month, the par value of the bond will increase with the rate of inflation. Semiannual coupon payments will be based on the new, inflation-adjusted par value of the bond. Thus, with positive inflation, not only will the maturity principal of the bond rise over time, but so will the size of the coupon payments.

As an example of how this IIB will work, consider an IIB with a 3.5-percent real coupon and assume inflation is constant at 3.0 percent per year. After six months, the coupon payment will be 3.5 percent of the new value of the principal. The new principal has risen in value by a half a year of inflation, so its new value is $100*(1+0.03)^(1/2) = $101.49. The first coupon payment becomes (0.035/2)*101.49 = $1.78. At maturity, the final principal value of the bond will be $134.29, and the final coupon payment will be $2.35. Thus, both the coupon payment and principal value have risen approximately 33 percent over 10 years due to inflation. Look at the chart on page 31 for a comparison of the coupon payments from an lib and a conventional bond with 3.5-percent interest.

The Treasury put a lot of effort into designing its IIB. The Department listened to Wall Street and, perhaps most importantly, it looked at the experiences of the United Kingdom, Australia, Canada and Sweden with their bonds to learn what not to do. The Treasury's bond is very similar to Canada's IIB, hence the frequent reference to the bond's "Canadian structure." The Treasury is also considering issuing 30-year and five-year IIBs later in 1997.

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