A bond, a new bond.

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.

WHAT'S ALL THE FUSS?

Normally, bond prices drop when interest rates increase and rise when interest rates fall. But it's important for corporate financial executives to understand the prices of inflation-indexed bonds can behave differently, depending on how inflation and real interest rates change. IIBs will force the market to become more aware of the components of nominal interest rates:

* Real interest rates. This is the rate of interest that would prevail if inflation didn't exist. One difficulty in measuring the real rate is we don't have any direct measures and must estimate it based on historical data (ex post measures). IIBs will change this because they will give the market an ex ante measure for the first time. Economists estimate that real interest rates have fluctuated between 2.0 percent and 5.0 percent over most of this century.

* Inflation expectations. Bondholders will also adjust prices and the nominal yields of bonds to account for any changes due to expected inflation. During this century, inflation in the United States has typically been positive, peaking at 13.1 percent in 1979. There have been a handful of years when inflation was negative (prices dropped 10.3 percent during one year of the Depression). The last year in which inflation was negative was 1954, so the market has built in a positive inflation expectation.

* Risk premiums for holding debt. Holders of conventional debt are subject to the risk that inflation will erode the purchasing power of their investment. They demand compensation in the form of a higher yield for exposure to this risk. The extra yield they demand is the inflation risk premium. Although estimates of this risk premium can range broadly from 10 basis points to 150 basis points, most analysts peg the risk premium at 30 to 50 basis points for the United States.

These components can interact in interesting ways, sometimes moving in tandem, sometimes diverging, and they can have some surprising effects on IIBs compared with conventional bonds. For example, the price of IIBs won't change as inflation expectations change or risk premiums change. The price of conventional bonds, however, will.

Rather, the price of IIBs will vary with experienced inflation. Since recent history indicates that inflation won't disappear (barring a sudden change in our monetary policy, such as a conversion to the gold standard), we can expect IIBs will rise in price over time, but that expectation won't be built into the current price of IIBs.

The price of IIBs will also depend on the real interest rate. If real interest rates rise, the value of IIBs will decline; if real interest rates decline, the value of IIBs will rise.

Most analysts expect real interest rates to be more stable than nominal interest rates. Studies have shown them to vary by a half to a third as much as nominal rates. These studies suffer from the problem of inferring real interest rates after the fact from historical data (ex post estimates), and they rarely take into account the inflation risk premium. IIBs will provide a true measure of the real interest rates (ex ante estimates). Analysts are expecting IIBs to be about half as volatile as conventional Treasury bonds. We also expect the yield curve for real interest rates to be flatter than the nominal yield curve.

THE ANALYSTS' TAKE

Suppose inflation surges unexpectedly, which in turn causes nominal interest rates to go up by 2 percent as inflation expectations increase by 2 percent. For simplicity, assume no change in real interest rates and the risk premiums demanded by investors for holding bonds subject to inflation risk. In this scenario, regular bonds are hurt badly. A 10-year conventional Treasury bond with a six-year duration will experience approximately a 12-percent loss in price. But IIBs will have a positive return: The price will rise by 2 percent, and interest payments will increase by 2 percent.

Over the long run, most analysts expect IIBs and conventional bonds will be correlated, despite instances where we expect them to diverge. Estimates of the correlation coefficients between IIBs and conventional bonds range from 0.3 to 0.7, which is much lower than the 0.9 to 0.99 correlation that most conventional bonds have with each other. Because of the low correlation coefficient, some analysts recommend they be classified as a separate asset class.

In general terms, consider IIBs a hybrid between cash and bonds. The returns of IIBs will be better than cash and cash equivalents, but lower than bonds of comparable maturity. Similarly, we expect the volatility of IIBs to be between those of cash equivalents and bonds. Like bonds, they'll offer maturities well over a year (remember, the Treasury is considering issuing a 30-year bond later this year) and offer semiannual coupon payments. Like cash, they'll track inflation over time and their yields will be lower than comparable maturity bonds (assuming positive inflation).

The really big question about the Treasury's new bond is the yield. We've never had a bond like this in the United States, so we don't have any experience in pricing them or estimating the size of demand for them. We must rely on the experience in other countries and some basic economic relationships to guess the yield.

The initial estimates by market analysts place the real yield guarantee of these bonds between 3.0 percent and 3.5 percent. Some speculate it could go as low as 2.0 percent if there's a niche segment of inflation-sensitive investors who decide to pay up for IIBs. Although the Treasury could take advantage of this group of investors, it doesn't want to upset initial purchases with subsequent rises in real yields. Thus, the Treasury seems to be hoping for a 3.0-percent to 4.0-percent range in yield.

HOW THE INFLATION-INDEXED BOND WORKS

Cash flow structure     Semiannual coupon bond with both coupon and
                        par value of bond indexed to inflation

Maturity                10 years

Inflation index         Consumer price index-urban (CPI-U),
                        non-seasonally adjusted as published by the
                        Department of Labor

Index adjustment        Value of CPI-U as reported for the third
                        preceding month and interpolated daily

Frequency of issuance   Quarterly, starting January 15, 1997

Right now, the Treasury is also mum about the issue size, only promising it will be between $2 billion and $10 billion. Within a few years, the Treasury hopes to be issuing $70 billion to $80 billion of IIBs annually. (The Treasury has no plans to replace the old conventional bonds completely. IIBs at best may make up about 15 percent of total debt issuance.)

The Treasury is a bit nervous about this initial auction. It's facing a typical chicken-and-egg problem. Nobody is committing to buy until they see a price (yield), but no price can be determined until there's an auction. In the meantime, a few bond managers are scoffing at the idea because IIBs won't offer a rate of return comparable to that of conventional bonds. They claim it will take a substantial period of inflation to compensate for their lower expected return. However, most seem to recognize the potential value of IIBs.

NOW WHAT DO I DO?

The most useful application of IIBs will be to protect conservative investors against inflation eroding the purchasing power of their portfolios. This will be particularly attractive to people near or in retirement who want a safe portfolio, especially since IIBs will be backed by the Treasury and have virtually no credit risk. Insurance companies, mutual funds and investment managers are all working on investment products that will be centered around IIBs. One problem for taxable investors is the IRS will tax both income and capital appreciation of the IIB. This is consistent with the IRS's treatment of zero-coupon bonds.

Despite a low projected rate of return, other long-term investors, such as pension funds, may also find a significant role for IIBs in their portfolios. The unique behavior of IIBs in response to the various components of interest rates will help diversify a portfolio, thus reducing volatility and allowing investors to take risks elsewhere if they so choose. IIBs will never replace equities, but it's quite conceivable that an asset allocation study will recommend they replace a part of the cash and intermediate bond allocation within a portfolio.

One area in which IIBs won't be an immediate help is in immunizing a pension plan's liabilities. Most pension liabilities are stated in nominal terms, not real terms, so conventional bonds will continue to be more appropriate for this type of assignment. In a broader asset/liability perspective, IIBs may be able to improve the asset portion of the program by moving some of the efficient portfolio frontiers in the desired direction.

Almost all bond managers will eventually use IIBs on a tactical level. A daring few will adopt them immediately and incorporate them into their long-run strategy, but most will use them on an opportunistic basis, dabbling in and out of them as they see inflation and real interest rates ebb and wane.

If IIBs are successful, they may change the nature of some financial products. With no guarantee of a real rate, insurance companies, pension plans and other providers of financial services have been unwilling to offer inflation-protected promises - for example, a life insurance policy that's indexed to inflation. IIBs may lay the framework for a new line of products.

IIBs aren't a revolutionary development. At worst, they're a marginal addition to a bond manager's toolbox. They satisfy a distinct need for inflation protection and rearrange the return and risks of fixed income investing in a unique way. Overall, they should be considered a relatively low-risk asset class that will provide a relatively low return. But their ability to protect against inflation can be extremely valuable. Corporate financial officers, as well as investors generally, should be aware of them - and willing to use them.

IN SHORT

* The price of inflation-indexed bonds will vary with experienced inflation. Since recent history indicates inflation won't disappear, IIBs most likely will rise in price over time.

* Analysts expect IIBs to be about half as volatile as conventional Treasury bonds.

* Analysts also estimate the real yield guarantee of these bonds between 3.0 percent and 3.5 percent.

* While IIBs may help diversify a pension portfolio, they won't immunize a pension plan's liabilities.

Dr. Finney is a principal based in Chicago with William M. Mercer Investment Consulting. You can reach him at [phone].