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.

"The Treasury bond and the Treasury inflation-protected securities markets are two of the largest and most-actively traded fixed-income markets in the world," the researchers write. "Despite this, we find that there are persistent arbitrage opportunities on a massive scale across these two markets. Furthermore, these arbitrages are almost invariably in one direction: Treasury bonds are consistently overpriced relative to TIPS.

"To the best of our knowledge, the relative mispricing of TIPS and Treasury bonds represents the largest arbitrage ever documented in the financial economics literature," they write.

"Perennially Treasury bonds are very, very rich relative to their value," co-author Francis Longstaff says. "The practical takeaway is that people seem to have this incredible appetite and interest in Treasury bonds and they are willing to pay extra for it beyond the present values of the cash flows. It is a great bargain for the Treasury to issue bonds, compared to TIPS, which aren't such a great bargain. It is like you can sell a $5 bill for six dollars if you call it a Treasury bond. Why would the Treasury ever issue TIPS? It is just a bad deal. If you are going to get $5 for selling a $5 bill, why do it when you can get $6?"

"The deeper issue here is that even in some of our most liquid markets there is some massive mispricing going on, which is taking everybody aback," he adds. "It is not some weird CDO market we don't know anything about, it is in the most visible, highest value, lowest-transaction-cost market we have."

So would the Treasury be willing to potentially save billions by killing TIPS issuances, or even buying them back and converting them to nominal bonds?

Francis thinks there are reasons to do so, but that proponents will muster their forces in opposition.

"Larry Summers is the one who originally came up with this idea by looking at what other countries were doing," says Longstaff, referring to the former president of Harvard University and top economic adviser to President Barack Obama. "Larry's point of view, as I understand it, was that by taking inflation risk off the table, people who bought TIPS don't have to worry about it, there would be less of a risk premium and the government could sell these bonds even more cheaply.

"That was the original idea," Longstaff says.

"What we found is that it has actually gone the other way. It is far from being cheaper -- it's actually more expensive to do this. The original story for why this is a good idea has been exploded. There may be other reasons for doing it, but it's certainly now you are playing defense. Why should we be wasting so much money?" he says. "You have to argue a lot more vehemently in favor of TIPS because the economics just doesn't seem to be there for these things."

-- Written by Joe Mont in Boston.

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