Indexed Treasuries Will Spawn New Trust Products

In January, the U.S. Treasury finally auctioned the first in a new series of inflation-indexed securities. With their penchant giving new products cute names, Wall Street professionals have started calling these notes TIPS, an acronym for Treasury Inflation-Protected Securities. Because they were issued in strippable form, TIPS will probably be converted into at least three new trust products that are likely to be popular with both individual and institutional trust clients. This article describes the new trust products that are likely to flow from TIPS, and the clients who are likely to buy them. The first issue of TIPS, a $7 billion offering of 10-year notes, was auctioned during the last week of January. The auction-determined real yield of those notes was 3.449% The principal amount, to be paid at maturity, will be inflationadjusted based on lagged changes in the Consumer Price Index. Semi-annual payments of interest on the notes will also be adjusted upward, based on changes in the CPI, by paying the real 3.449% rate on the inflation- adjusted principal amount. If the government changes the CPI, per the Boskin Task Force's recommendations, the Treasury has indicated it will prevent such a change from reducing the yield on TIPS by adopting an alternative index. The box on this page summarizes other important technical features of TIPS. Because the initial $7 billion offering was over-subscribed by about $30 billion, it is likely that future issues will also be well received as the public learns more about TIPS. In fact, other quasi-governmental agencies such as the Federal Home Loan Banks, Government National Mortgage Association, Federal National Mortgage Association, and the Tennessee Valley Authority have already either begun to issue their own inflation-indexed bonds or are developing plans to do so. However, the tax features of TIPS will almost certainly make them attractive mainly to tax-sheltered individuals, pension funds, and other institutional clients of bank trust departments. The fact that inflation-adjusted increments in the principal value of TIPS are taxable on a current basis, while the investor's principal isn't actually paid until the securities mature, make TIPS unattractive to investors who are not tax-sheltered. Moreover, this cash-flow versus tax-liability mismatch inherent in TIPS probably means that most banks will not carry them in their own securities portfolios. A POTENTIALLY LARGE MARKET The marketing of TIPS and their derivative products is likely to unfold roughly as follows. First, some of the initial bidders who purchased them as individuals will likely hold TIPS, unaltered, in their own tax-sheltered retirement accounts, i.e. IRAs, 401(k)s, 403(b)s, Keoghs, etc. Many bank trust departments received calls in January, from existing clients, placing competitive or non-competitive orders for TIPS. Trust officers should, of course, be prepared for more such calls as future quarterly issues of TIPS come to market. Although the Treasury hasn't revealed its long-term plans for issuing TIPS, Britain has about 12% of its national debt funded by such securities. That would translate into over $600 billion of U.S. TIPS, based on our current national debt, a potentially huge secondary market. In fact, even with only one issue currently outstanding, the secondary market for TIPS is already in operation, providing a ready source of such securities for trust customers who may want to purchase them after they have been issued. As the outstanding volume of outstanding TIPS expands, the bid/asked spreads on them can be expected to narrow toward the normal Treasury spreads. The next phase of TIPS marketing, which has already begun, will involve creating a variety of derivative products. The first and simplest such product will be a TIPS mutual fund. Because mutual funds have to cover their expenses and earn a profit, the inflation-indexed yield to individual trust customers will of course be somewhat lower than they could earn by buying TIPS directly from the Fed. …