Treasury's 'Inflation Bonds' Are About Safety, Not Big Gain

Move over, US savings bonds. Make room, conventional US Treasury bonds, bills, and notes. Watch out, corporate triple-As and high-yield "junk" bonds!

Inflation-indexed bonds are coming to town, and if they prove even modestly successful, the beneficiaries could include not just its issuer - the United States Treasury - but thousands of middle-class Americans eager to find a hedge against inflation.

The new product was touted by President Clinton last week, five months after it was first proposed by Treasury Secretary Robert Rubin. It attempts to solve a key problem with fixed-income investments: Inflation erodes their value over time.

Here are answers to some of the most frequently asked questions about the new bonds:

When will the bonds become available?

Mr. Clinton says the bonds will be available Jan. 15, and will be offered in increments of $1,000. The maturity period will be 10 years. After January, they will be offered on a quarterly basis - in April, July, and October.

The Treasury also promises to offer by January 1998 inflation-protected savings bonds sold in denominations as low as $50.

Has anyone ever tried anything like this before?

Yes. Britain, Canada, Australia, New Zealand, Israel, France, and Brazil currently offer inflation-adjusted bonds. According to financial information-firm H.C. Wainwright & Company in Boston, 15 percent of Britain's public debt is covered by inflation-linked bonds, first issued there in 1981.

What will be the yardstick to measure inflation?

The consumer price index, which measures changes in the price of food, housing, transportation, energy, and other consumer goods and services.

Who will buy the bonds?

Probably both big institutional investors, such as pension funds, and smaller savers. It is also expected that some mutual-fund products will be set up to buy the bonds, thus allowing smaller investors to buy the bonds indirectly.

Is the bond a good deal for the small investor?

The concept of an inflation-indexed Treasury bond sounds "very attractive" for small savers, says Lacy Herrmann, chairman of the Aquila Group of mutual funds in New York.

Under the Treasury plan, the value - or principal - of the bond will change with the inflation rate. Say you buy a $1,000 bond with a stated interest rate of 3 percent. If inflation goes up 3 percent over the course of a year, the value of the bond would be adjusted upward by 3 percent to $1,030. Your interest payment would be computed on that adjusted amount ($1,030 times 3 percent, which equals $30.90.) Interest payments will be semiannual, so the actual computation will be done twice a year.

But if there is a period of deflation (falling prices), the value of the principal, and thus, your interest payments, would decrease. But you are guaranteed to get back the face value of the note - $1,000 for example - at the end of the maturity period.

So the bonds are not really designed to let me make a lot of money?

They are super-conservative; they essentially preserve the value of your capital with some gain. They are not designed to provide much growth in wealth. For growth, you would need to look elsewhere, such as higher-yield corporate bonds and stocks, financial planners say.

Still, if interest rates are in the range of 3 to 4 percent - as some experts predict, the bonds could be a good deal by historical standards. Long-term government bonds have only beaten inflation by two percentage points a year since 1926, according to Ibbotson Associates, a research firm in Chicago.

How will the guaranteed interest rate be set?

At public auction, as is now the case for regular Treasury sales.

How will the bonds be taxed?

The Treasury says principal appreciation and interest payments will be taxed annually as ordinary interest income for federal income-tax calculations. They will be exempt from state and local taxes. Interest earnings and price appreciation from notes held in retirement plans such as pension funds, 401(k) accounts, and individual retirement accounts will not be taxed annually. In those accounts, taxes are paid when earnings are withdrawn, usually after retirement and thus probably at a lower rate.

Where can I buy them?

Through the "Treasury Direct" program, (202) 874-4000 or (202) 874-4000, or from the 12 regional Federal Reserve banks. You can also buy them from brokers, but you will have to pay a standard $40 to $50 commission.

How will the US Treasury benefit?

If the bonds encourage greater saving by Americans, the larger savings pool could mean lower interest charges for all borrowers. Also, the Treasury might have lower interest expenses if investors were to miscalculate future inflation rates. But H.C. Wainwright, looking at the British precedent, expects forecasting mistakes to cancel each other out; thus the Treasury would save little if anything on interest charges. The coupon yield on the new bonds is expected to be about half that of non-indexed Treasury notes. Interest expense on federal debt was $232 billion in 1995.

Will the bonds be an indicator of future inflation?

Yes. The spread between the interest rates on indexed and non-indexed bonds, set by investors at Treasury auctions, should give Federal Reserve officials a measure of expected inflation. This may prove useful in deciding monetary policy.

But the new bonds bother some analysts. "I worry that this may mean that the federal government is saying that it cannot get control of inflation," says Mr. Herrmann.

What impact will the bonds have on the stock market?

Some money "might flow from stocks to the new bonds," says David Blitzer, chief economist at Standard & Poor's Corp. in New York. The spread between yields on stocks and bonds has been narrowing. This new bond, with its built-in anti-inflation guarantees, "will help narrow that gap even more," Mr. Blitzer says. Still, studies show that over time, stocks have consistently outperformed bonds, according to analysis by Ibbotson.