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TheStreet Open House

Government Keeps Losing With TIPS

BOSTON ( TheStreet) -- While investors consider hedging against inflation by buying Treasury-issued TIPS bonds, there is a question of whether they are worthwhile for the government itself. It's left billions of dollars on the table by issuing them.

The dilemma is detailed in a research paper, Why Does the Treasury Issue TIPS? The TIPS-Treasury Bond Puzzle", written under the auspices of the National Bureau of Economic research by Matthias Fleckenstein, Francis Longstaff and Hanno Lustig of the University of California at Los Angeles.

The government introduced Treasury Inflation-Protected Securities in 1997, and some economists are newly wondering why.

"The price of a Treasury bond and an inflation-swapped Treasury inflation-protected securities issue exactly replicating the cash flows of the Treasury bond can differ by more than $20 per $100 notional," the face value used to calculate payments, says a study being distributed and presented throughout the economics community. "Treasury bonds are almost always overvalued relative to TIPS. Total TIPS-Treasury mispricing has exceeded $56 billion, representing nearly 8% of the total amount of TIPS outstanding."

Translated into yields, the average size of the arbitrage is 54.5 basis points, but can exceed 200 basis points for some pairs. On Jan. 30, 2009, the Treasury issued $14 billion of 20-year TIPS at a cost of $12 per $100 notional. This issuance alone cost the Treasury $1.7 billion, the study says.

"TIPS-Treasury mispricing is strongly related to supply factors such as Treasury debt issuance and the availability of collateral in the financial markets, and is correlated with other types of fixed-income arbitrages," the researchers add. "These results pose a major puzzle to classical asset-pricing theory. In addition, they raise the issue of why the Treasury issues TIPS, since in so doing it both gives up a valuable fiscal hedging option and leaves large amounts of money on the table."

Back in 1997, after a decade-plus push originating during the Reagan administration, the government introduced Treasury Inflation-Protected Securities, inflation-indexed bonds with five-, 10- and 30-year maturities. Adjustments are made using the Consumer Price Index. Before that year's auction of $7 billion of 10-year TIPS, all U.S. debt was nominal debt, as in traditional Treasury bonds.

TIPS are available through brokerages, as well as directly from the government. (Other choice for investors are the various mutual funds and ETFs built around laddered TIPS.) In periods of steadily low inflation, as we've experienced in recent years, returns can be minimal. Deflation can even erode returns below the baseline face value (or inflation-adjusted face value), even if a security is held to maturity, once taxes are factored in. Nevertheless, investors are increasingly seeing TIPS as a suitable hedge against rising inflation rates -- something starting to materialize for the first time in many months.

The bonds have proven to be particularly popular additions to tax-sheltered retirement plans such as 401(k)s and IRAS, as the interest is taxed at ordinary income tax rates.

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