U.S. Treasury Inflation-Indexed Bonds

Abstract

RICHARD ROLL is the Allstate professor of finance at the Anderson School at the University of California at Los Angeles. n May 1996, the U.S. Treasury announced its intention to issue “inflation protection” bonds with cash payments linked to a general price index. It solicited the opinions of interested parties about the form of such a security, and engaged in several months of collective security design. This is surely one of the most interesting episodes in the history of U.S. fixed-income markets, for the Treasury has never before issued an indexed bond. If it is properly designed, it will be among the least risky of all assets, virtually immune to both default and inflation risks. Hence, it is destined to become the datum for all other fixed-income securities. In its official request for suggestions on May 15, the Treasury asked about five specific design issues: 1) the inflation index; 2) the cash flow structure; 3) maturities; 4) the auction mechanism; and 5) amounts. This article discusses each question and describes the choices made for the first bond, scheduled to be auctioned in January. Most attention is given to the structure. Four structures were considered, and each has its attractions and drawbacks. Although the structure of the first Treasury indexed bond has now been announced, future bonds may well have other structures. The central conundrum here, as with any security’s design, is the trade-off between broad market liquidity and spec& structures that appeal to indwidual clientele groups. The Treasury could issue many Merent indexed bonds in an effort to obtain hgh prices from heterogeneous investors. If tastes change, however, each small issue might have limited secondary market liquidty. To maximize proceeds and minimize Treasury borrowing costs, there has to be a compromise between ,

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