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Why inflation-indexed Treasury Securities are not well suited for discounting a future earning steam.

Inflation-indexed Treasury Securities (TIPS) were initially auctioned by the U.S. Treasury in late January, 1997. A second issue in July, 1997, offered shorter maturity bonds. The bonds were issued with 10- and 5-year maturities respectively, a premium guarantee that they will pay a real rate of interest above inflation, and a face value which will not drop below the value at issue should deflation occur. Presently, (4/8/98) the inflation-indexed yield to maturity ranges from 3.72% to 3.82% real interest on the 10and 5-year maturities respectively.

The indexing feature would seem to make these bonds a reasonable instrument for calculating the present value of diminished earning capacity, because their return is guaranteed by the U.S. Treasury to provide a hedge against inflation. These bonds should therefore represent a safe and prudent vehicle which is available to an unsophisticated investor as recipient of lump sum settlement or jury award. Upon closer inspection however, it is clear that these bonds are a less than desirable instrument for this purpose.

The reasons that they represent a poor tool for discounting to present value are several:

1. The inflation adjusted principal is paid to an account which accrues to the value of the bond, and is not payable until maturity. This means that if a portfolio of the bonds is used to replace future diminished earning capacity between now and the maturity date, a portion of the bonds must be sold, thereby losing some of the inflation-indexed principal accrual to maturity.

2. The indexed principal payments, although unavailable until maturity, are subject to Federal income taxation in the year they are credited. That is, the bond holder must pay taxes on these credits as income, even though they cannot be spent. Of course, interest income which results from any instrument other than municipal bonds will result in income tax liability, whether spent or not. The difference with TIPS is that the indexed income is not available until maturity, unless adjusted for and sold in the secondary market.

3. The secondary market for TIPS is not well established at this point. No one knows how active or liquid this market will be in the future. Some argue that the marketability of TIPS is likely to increase as they become a more well-known and popular instrument, although actual bidding slowed to a trickle with each of the government's subsequent auctions of the inflation-indexed bonds. (Wall Street Journal, April 7, 1998) The small investor may therefore pay higher transaction costs and receive lower overall return. Bond markets for fixed principal T-Bills and Bonds, are far better established, historically have paid rates which are as good as, or which exceed the TIPS rate, and do not have the downside liquidity risk. Example: Fixed principal T-Bonds with 10-year maturities were paying 5.51% on April 7, 1998, as quoted in the Wall Street Journal. The increase in the CPI-U for all items in the year ending February, 1998 was 1.4% as quoted by the Bureau of Labor Statistics on April 8, 1998. This leaves a real interest rate on 10-year T-Bonds of 4.11%, which is approximately 0.39% higher than the current real rate on the indexed Bonds of the same maturity. Of course, in periods of higher inflation, the indexed bonds are likely to produce a higher yield than regular T-Bonds. The quid pro quo of this however, is that if inflation rises, or if there is a threat of rising inflation, bond prices will decline. The overall return to the bond holder in this situation may be flat or negative. The resulting advantage may fall to the individual who buys bonds when prices are lower and the yields are higher. This raises the issue of market timing and uncertainty.

4. The fourth problem is the length of maturity. This problem applies to all long bonds and should not perhaps be specifically an argument against using TIPS. The purpose of selecting a short term security (91-day or 6-month T-Bills) is that they avoid most inflation risk as well as minimizing market risk. These securities can be rolled over at short maturities to provide an appropriate replacement of the lost income stream, without risking the volatility in prices of long bonds caused by threats of inflation and market response. As alluded to above, a 1% increase in the threat of inflation or interest rates can translate into a 10 or 11% drop in overall return of the long bond. This means that if the individual must sell bonds at an inopportune time in order to replace lost income, they may take an unreasonable loss. He or she may then find it necessary to sell more bonds to replace the lost stream payment, thus prematurely depleting the requisite funds to continue their income replacement to the end of their worklife expectancy. Specifically with respect to their current issues of 10and 5-year maturities, TIPS are subject to these same inflation and market risks.

Inflation-indexed Treasury Securities therefore entail risks and uncertainties with respect to taxes, liquidity, and yield competitiveness, which are greater than those encountered with fixed principal government securities of similar maturities. In light of these risks, and the necessity that the discounting vehicle be appropriate for the unsophisticated investor, these new securities are a poor tool for use as an investment vehicle designed for the replacement of a future earning stream.

Kent A. Jayme, M.A., C.R.C., C.L.C.P., C.C.M. and Diplomate, American Board of Vocational Experts
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Author:Jayne, Kent A.
Publication:Journal of Forensic Economics
Date:Jan 1, 1998
Words:921
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