| Trust & Investment Products |
In January, the U.S. Treasury finally auctioned the first in a new series of inflation-indexed securities. With their penchant for 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 inflation-adjusted 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. Moreover, as the volume of TIPS expands, self-directed pension funds will begin to include TIPS mutual funds as an additional investment option.
Because the Treasury issues these securities in strippable form, two other derivative products will also naturally flow from them. One is zero-coupon inflation-indexed principal payments (likely to be dubbed ZIPs). The other is an inflation-indexed stream of interest-only payments, which is actually an inflation-indexed annuity.
Because the zero-coupon product is indexed for inflation, it should exhibit less price volatility than a normal zero-coupon bond. It is an ideal product for younger conservative investors who are saving for retirement, using IRAs, Keoghs or other tax-sheltered accounts. Pension funds managed by conservative trustees are also likely buyers of both TIPS and ZIPS.
The other TIPS derivative, as noted above, is the inflation-indexed annuity. Because the cash flow from these annuities is more closely tied to the tax liabilities flowing from them, this product may also be of interest to conservative investors who are not tax-sheltered and just want an inflation-protected annuity.
For bank trust officers, the bottom line is that TIPS are an interesting new instrument that will spawn a variety of new products for your clients. Stay alert for new marketing opportunities as the "rocket scientists" begin to develop and distribute the derivative products.
| Summary of Treasury Inflation-Indexed Securities | |
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The inflation-indexed securities will be structured similarly to the Real Return Bonds issued by the Government of Canada. The real interest rate, which is set at auction, will remain fixed throughout the term of the security. Semiannual interest payments will be based on the inflation-adjusted principal at the time the interest is paid. (Example on opposite page.) The principal amount of the security will be adjusted for inflation periodically, but the inflation-adjusted principal will not be paid until maturity. At maturity, the securities will be redeemed at the greater of their inflation-adjusted principal or the par amount at original issue, if there is no inflation or if prices actually fall during the next ten years. The index for measuring the inflation rate will be the non-seasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U), published monthly by the Bureau of Labor Statistics (BLS). If, while an inflation-indexed security is outstanding, the CPI is (1) discontinued, or (2) in the judgment of the Secretary, fundamentally altered in a manner materially adverse to the interests of an investor in the security, or (3) in the judgment of the Secretary, altered by legislation or executive order in a manner materially adverse to the interests of an investor in the security, Treasury, after consulting with the BLS, will substitute an appropriate alternative index. These securities are exempt from state and local taxes but subject to federal income taxation. Generally, the amount of any inflation adjustment will be taxable as income within that year. (For additional tax information see IRS Notice 96-51) The securities will be eligible for stripping into their principal and interest components in Treasury's Separate Trading of Registered Interest and Principal of Securities (STRIPS) program. | |
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