Why inflation-indexed bonds are a bad deal for corporate investors.

AuthorSmith, Robert G.

In January 1997, when politicians and policymakers decided to issue index-linked Treasury notes, Treasury officials' reason for implementing the inflation-indexed financing program was to achieve a lower cost of federal funding while expanding the market for U.S. debt securities. Interest savings are based on the assumption that the Treasury can capture most of an inflation risk premium embedded in nominal bond yields and will benefit from a further decline in inflation. But given the disinflation of recent years and a stable monetary policy recognized by bond market participants, the inflation portion of the overall bond yield risk premium looks minimal and near-full recoupment could prove elusive. This is evident given the index rebenchmarking risk that the CPI measurement could be adjusted to reduce the measured rate of inflation. (Returns on inflation-indexed bonds are adjusted in response to fluctuations in the CPI.)

Furthermore, the returns on inflation-indexed bonds are likely to prove sensitive to monetary policy. If the Federal Reserve maintains a vigorous anti-inflation stance that keeps it in check - as Chairman Greenspan appears determined to continue - the return on these securities will be depressed. Of course, if the Fed becomes passive or lax, allowing inflation to rise, indexed issues will outperform nominal bonds.

Given the current low inflation expectations, the likelihood of a favorable outcome for these issues is limited. As the fanfare over their introduction continues to wane, investors may demand some extra yield to compensate for what is beginning to look like a relatively illiquid secondary market.

POLITICAL UNDERPINNING

The Clinton Administration continues to pursue an aggressive program of shortening the average maturity of Treasury debt to reduce current interest costs. By shifting issuance into shorter maturities and taking advantage of the steep yield curve, the Treasury made significant reductions in interest expense. This, in turn, permitted the administration to present budgets showing continuous deficit reductions while sparing favored domestic spending programs from severe cuts.

However, the Treasury recognizes that shifting borrowing into shorter notes and bills has practical limits. This is especially true because the market has displayed periodic bouts of indigestion from the sharp increase in short-term issuance. By issuing inflation-indexed securities, the Treasury can alleviate the supply glut at...

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