| GENERAL
DESCRIPTION
Treasury inflation-indexed securities (TIIs) are issued by the Treasury Department
and represent direct obligations of the United States government. The securities
are designed to provide investors with a hedge against increases in inflation.
The initial auction of these relatively new
securities was held in January 1997, when a 10-year note was issued. Various
longer-term maturities are planned for future auctions, which will be held quarterly.
TIIs have very little credit risk, since they are backed by the full faith and
credit of the U.S. government. Banks can be designated as primary dealers of
Treasury securities, but they may sell them in the secondary markets and invest
in TIIs for their own account.
CHARACTERISTICS
AND FEATURES
TIIs were created to meet the needs of longer-term investors wanting to insulate
their investment principal from erosion due to inflation. The initial
par amount of each TII issue is indexed to the nonseasonally adjusted Consumer
Price Index for All Urban Consumers (CPI-U). The index ratio is determined by
dividing the current CPI-U level by the CPI-U level that applied at the time
the security was issued or last reindexed. If there is a period of deflation,
the principal value can be reduced below par at any time between the date of
issuance and maturity. However, if at maturity the inflation-adjusted
principal amount is below par, the Treasury will redeem the security at
par. Every six months, interest is paid based on a fixed rate determined at
the initial auction; this rate will remain fixed throughout the term of the
security. Semiannual interest payments are determined by multiplying the inflation-adjusted
principal amount by one-half the stated rate of interest on each payment date.
TIIs are eligible for stripping into their principal and interest components
under the Treasury's STRIPS program.
Similar to zero-coupon bonds,
TIIs are tax disadvantaged in that investors must pay tax on the accretion to
the principal amount of the security, even though they do not currently receive
the increase in principal in cash. Paying tax on income not received reduces
the effective yield on the security.
The following example illustrates how TIIs work: suppose an investor
purchases a $1,000 note at the beginning of the year, in which the interest
rate set at the time of the auction is 3 percent. Also suppose that inflation
for the first year of the note is 3 percent. At the end of the first year, the
$1,000 principal will be $1,030 reflecting the increase in inflation, although
the investor will not receive this increase in principal until maturity. The
investor will receive, however, the 3 percent interest payment. At the end of
the first year, the notes will be paying 3 percent interest on the increased
principal balance of $1,030. Principal will be adjusted each year, based on
the increase or decrease in inflation.
USES
At present, the primary strategy behind the purchase of a TII
would be to hedge against erosion in value due to inflation. However, banks
also use TIIs for investment, hedging, and speculative purposes. As TIIs are
tax disadvantaged, they are most likely to appeal to investors who are not subject
to tax.
An investor in TIIs is taking a view that real interest rates
will fall. Real interest rates are defined as the nominal rate of interest less
the rate of inflation. If nominal rates fall, but inflation does not (that is,
a decline in real interest rates), TIIs will appreciate because their fixed
coupon will now represent a more attractive rate relative to the market. If
inflation rises, but nominal rates rise more (that is, an increase in real interest
rates), the security will decrease in value because it will only partially adjust
to the new rate climate.
DESCRIPTION
OF MARKETPLACE
Issuing Practices
The auction process will use a single pricing method identical to the one
used for two-year and five-year fixed-principal Treasury
notes. In this type of auction, each successful competitive bidder and each
noncompetitive bidder is awarded securities at the price equivalent to the highest
accepted rate or yield.
Market Participants
Sell Side
Like all U.S. government securities, TIIs are traded over the
counter, with the primary government securities dealers being the largest and
most important market participants. A small group of interdealer brokers disseminate
quotes and broker trades on a blind basis between primary dealers and users
of the Government Securities Clearing Corporation (GSCC), the private clearinghouse
created in 1986 to settle trades for the market.
Buy Side
A wide range of investors are expected to use TIIs for investing,
hedging, and speculation, including commercial and investment banks, insurance
companies, pension funds, mutual funds, and individual investors. As noted above,
TIIs will most likely appeal to investors who are not subject to tax.
Market Transparency
Price transparency is relatively high for Treasury securities since several
information vendors disseminate prices to the investing public. Govpx, an industry-sponsored
corporation, disseminates price and trading information via interdealer broker
screens. Prices of TIIs are active and visible.
RISKS
Interest-Rate Risk
TIIs are subject to price fluctuations because of changes in
real interest rates. TIIs will decline in value if real interest rates increase.
For instance, if nominal interest rates rise by more than the increase in inflation,
the value of a TII will decrease because the inflation component will not fully
adjust to the higher level of nominal rates in the market. As the coupon rate
on TIIs is well below market for similar maturity instruments, the duration
of TIIs will be higher, increasing the price sensitivity of the instrument for
a given change in real interest rates. Also, the CPI-U index used in calculating
the principal accretion on TIIs is lagged three months, which will hurt the
investor when inflation is rising (and help the investor when inflation is falling).
Longer-term issues will have more price volatility than shorter-term
instruments. A large concentration of long-term maturities may subject a bank's
investment portfolio to unwarranted interest-rate risk.
Liquidity Risk
The Treasury securities market is the largest and most liquid
in the world. While an active secondary market for TIIs is expected, that market
initially may not be as active or liquid as the secondary market for Treasury
fixed-principal securities. In addition, as a new product, TIIs may not be as
widely traded or well understood as Treasury fixed-principal securities. Lesser
liquidity and fewer market participants may result in larger spreads between
bid and asked prices for TIIs relative to the bid/ask spreads for fixed-principal
securities of the same maturity. Larger bid/asked spreads normally result in
higher transaction costs and/or lower overall returns. The liquidity of the
TII market is expected to improve over time as additional amounts are issued
and more entities enter the market.
LEGAL LIMITATIONS FOR BANK INVESTMENT
TIIs are a type I security so there are no legal limits on a
bank's investment in them.
REFERENCES U.S. Department of the Treasury.
Buying Trea-sury Inflation-Indexed Securities. Washing-ton, D.C.: The Bureau
of the Public Debt, 1997.
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