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Profiles: Treasury Inflation-Indexed Securities GENERAL DESCRIPTION Treasury inflation-indexed securities (TIIs) are issued by the Treasury Department and represent direct obligations of the United States government. The securities are designed to provide investors with a hedge against increases in inflation. The initial auction of these relatively new securities was held in January 1997, when a 10-year note was issued. Various longer-term maturities are planned for future auctions, which will be held quarterly. TIIs have very little credit risk, since they are backed by the full faith and credit of the U.S. government. Banks can be designated as primary dealers of Treasury securities, but they may sell them in the secondary markets and invest in TIIs for their own account. CHARACTERISTICS AND FEATURES TIIs were created to meet the needs of longer-term investors wanting to insulate their investment principal from erosion due to inflation. The initial par amount of each TII issue is indexed to the non-seasonally adjusted Consumer Price Index for All Urban Consumers (CPI-U). The index ratio is determined by dividing the current CPI-U level by the CPI-U level that applied at the time the security was issued or last re-indexed. If there is a period of deflation, the principal value can be reduced below par at any time between the date of issuance and maturity. However, if at maturity the inflation-adjusted principal amount is below par, the Treasury will redeem the security at par. Every six months, interest is paid based on a fixed rate determined at the initial auction; this rate will remain fixed throughout the term of the security. Semi-annual interest payments are determined by multiplying the inflation-adjusted principal amount by one-half the stated rate of interest on each payment date. TIIs are eligible for stripping into their principal and interest components under the Treasury's STRIPS program. Similar to zero-coupon bonds, TIIs are tax disadvantaged in that investors must pay tax on the accretion to the principal amount of the security, even though they do not currently receive the increase in principal in cash. Paying tax on income not received reduces the effective yield on the security. The following example illustrates how TIIs work: suppose an investor purchases a $1,000 note at the beginning of the year, in which the interest rate set at the time of the auction is 3 percent. Also suppose that inflation for the first year of the note is 3 percent. At the end of the first year, the $1,000 principal will be $1,030 reflecting the increase in inflation, although the investor will not receive this increase in principal until maturity. The investor will receive, however, the 3 percent interest payment. At the end of the first year, the notes will be paying 3 percent interest on the increased principal balance of $1,030. Principal will be adjusted each year, based on the increase or decrease in inflation. USES At present, the primary strategy behind the purchase of a TII would be to hedge against erosion in value due to inflation. However, banks also use TIIs for investment, hedging, and speculative purposes. As TIIs are tax disadvantaged, they are most likely to appeal to investors who are not subject to tax. An investor in TIIs is taking a view that real interest rates will fall. Real interest rates are defined as the nominal rate of interest less the rate of inflation. If nominal rates fall, but inflation does not (that is, a decline in real interest rates), TIIs will appreciate because their fixed coupon will now represent a more attractive rate relative to the market. If inflation rises, but nominal rates rise more (that is, an increase in real interest rates), the security will decrease in value because it will only partially adjust to the new rate climate. DESCRIPTION OF MARKETPLACE Issuing Practices The auction process will use a single pricing method identical to the one used for two-year and five-year fixed-principal Treasury notes. In this type of auction, each successful competitive bidder and each non-competitive bidder is awarded securities at the price equivalent to the highest accepted rate or yield. Market Participants Sell Side Like all U.S. government securities, TIIs are traded over the counter, with the primary government securities dealers being the largest and most important market participants. A small group of inter-dealer brokers disseminate quotes and broker trades on a blind basis between primary dealers and users of the Government Securities Clearing Corporation (GSCC), the private clearinghouse created in 1986 to settle trades for the market. Buy Side A wide range of investors are expected to use TIIs for investing, hedging, and speculation, including commercial and investment banks, insurance companies, pension funds, mutual funds, and individual investors. As noted above, TIIs will most likely appeal to investors who are not subject to tax. Market Transparency Price transparency is relatively high for Treasury securities since several information vendors disseminate prices to the investing public. Govpx, an industry-sponsored corporation, disseminates price and trading information via inter-dealer broker screens. Prices of TIIs are active and visible. RISKS Interest-Rate Risk TIIs are subject to price fluctuations because of changes in real interest rates. TIIs will decline in value if real interest rates increase. For instance, if nominal interest rates rise by more than the increase in inflation, the value of a TII will decrease because the inflation component will not fully adjust to the higher level of nominal rates in the market. As the coupon rate on TIIs is well below market for similar maturity instruments, the duration of TIIs will be higher, increasing the price sensitivity of the instrument for a given change in real interest rates. Also, the CPI-U index used in calculating the principal accretion on TIIs is lagged three months, which will hurt the investor when inflation is rising (and help the investor when inflation is falling). Longer-term issues will have more price volatility than shorter-term instruments. A large concentration of long-term maturities may subject a bank's investment portfolio to unwarranted interest-rate risk. Liquidity Risk The Treasury securities market is the largest and most liquid in the world. While an active secondary market for TIIs is expected, that market initially may not be as active or liquid as the secondary market for Treasury fixed-principal securities. In addition, as a new product, TIIs may not be as widely traded or well understood as Treasury fixed-principal securities. Lesser liquidity and fewer market participants may result in larger spreads between bid and asked prices for TIIs relative to the bid/ask spreads for fixed-principal securities of the same maturity. Larger bid/asked spreads normally result in higher transaction costs and/or lower overall returns. The liquidity of the TII market is expected to improve over time as additional amounts are issued and more entities enter the market. ACCOUNTING TREATMENT The accounting treatment for investments in Treasury inflation-indexed securities is determined by the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 115, ''Accounting for Certain Investments in Debt and Equity Securities,'' as amended by SFAS 125, ''Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.'' SFAS 125 has been replaced by SFAS 140, which has the same title. Accounting treatment for derivatives used as investments or for hedging purposes is determined by SFAS 133, ''Accounting for Derivatives and Hedging Activities.'' (See section 2120.1, ''Accounting,'' for further discussion.) RISK-BASED CAPITAL WEIGHTING TIIs have a 0 percent risk weighting. For specific risk weights for qualified trading accounts, see section 2110.1, ''Capital Adequacy.'' LEGAL LIMITATIONS FOR BANK INVESTMENT TIIs are a type I security so there are no legal limits on a bank's investment in them. REFERENCES U.S. Department of the Treasury. Buying Treasury Inflation-Indexed Securities. Washington, D.C.: The Bureau of the Public Debt, 1997. Continue to U.S. GOVERNMENT AGENCY SECURITIES Back to Activities Manual Index |