The Treasury Department's inflation-indexed bonds, relatively new financial instruments that so far haven't proved popular with healthcare buyers, might play better in the market at their next auction April 15 than they did at their previous five outings.
The reason? The long period of low inflation the nation has enjoyed. The bonds, which have a lower coupon rate than traditional Treasury bonds, are linked to the Consumer Price Index. When inflation rises, the principal of the bond increases by the same percentage. The bonds provide a hedge, with investors betting the inflation rate will trend higher.
Inflation-indexed bonds might be more attractive now because inflation has been sitting at very low rates-only 1.8% in 1997. Investors who believe inflation will only rise from this level might want to consider this investment, says Christopher Kinney, fixed-income portfolio manager at Brown Brothers Harriman & Co. in New York.
"I personally think it's unlikely inflation will be less than 1.8% for the next 10 years," says Kinney, who runs a $13 million inflation-indexed securities fund for Brown Brothers.
And while the yield on these bonds might seem relatively low-between 3.45% and 3.70%-it represents a real return that takes inflation into consideration. Nominal rates on traditional Treasury bonds don't do that.
Here's an example of how the bonds work: The Treasury issues an inflation-indexed bond worth $1,000 at a 3.5% interest rate, and inflation increases to 3% for the year. At the end of the year, the principal on the inflation-indexed bond would be marked up 3% to $1,030 to reflect inflation. The 3.5% interest payment would then be based on the $1,030 bond for that year, paying out $36.05. In simple terms, the sum of inflation adjustment plus the coupon would equal a 6.05% gain for the year.
By contrast, a traditional bond worth $1,000 with a 6% interest rate would yield a $60 interest payment for the year; because it's not adjusted for inflation, the traditional bond would be worth slightly less than the inflation-indexed bond for that year.
Some observers say the investment might be ideal for long-term investors with asset pools-for instance, foundations or endowment funds, including many healthcare organizations-because they guarantee consistent income over a long time. With today's volatile healthcare market, these bonds can lock in a real rate of return if inflation increases. And despite the huge run-up in the stock market, healthcare systems are still looking to invest a sizable portion of their assets in conservative instruments (March 16, p. 62).
The key to inflation-indexed bonds is that they can be less volatile than traditional Treasury bonds and equities. While Kinney says the bonds can't compete with the returns provided by equities, they offer a guarantee against loss of principal to risk-averse investors.
"This is a constant income stream that's guaranteed by the Treasury," Kinney says. "That makes it unique."
They're also more attractive than other hedges against inflation like real estate investments and gold, Kinney says. Real estate isn't a liquid investment and requires intensive analysis and management. Gold has been tarnished because it provides no dividends and its value usually is tied to political events, he says.
So far, these bonds have not been popular because inflation has been in check. When they were first issued in 1997, inflation was at 3.3%. So investors in the bonds during that time have seen returns decline as inflation decreased by 1.5 percentage points.
And even though the bonds guarantee a real return rate, they are a hard sell because of competing double-digit returns from Wall Street during the strong bull market the past several years.
Fighting the allure of those recent stock market returns has been a challenge, says Louis Finney, director of capital market research for William M. Mercer in Chicago.
"Investors are so swayed by the recent performance of the equity markets. . . . In some cases we're trying to get clients not to get too excited about investing too much in equities," Finney says. "It's going to take a burst of inflation to spark widespread interest in these bonds."
Alan Broude, senior vice president and chief financial officer for Jewish Hospital in Louisville, Ky., says his system hasn't invested in inflation-indexed bonds, nor will he consider them. In all its asset pools, Jewish is moving more into equities, which can provide a rate of return that dwarfs the bonds' returns, he says.
"I can't see many professional money managers getting out that way (into inflation-linked bonds) until the economy turns tremendously," Broude says.
Still, Finney says institutional investors are starting to warm up to the bonds' advantages. The investment is just over a year old, so investors were expected to need some time to understand it, he added.
"We are getting to a point where we can talk to clients about them on a strategic basis," he says.
Because of slowly rising inflationary fears, the next auction April 15 may be the first time inflation-indexed bonds have a shot at proving themselves, Kinney predicts. The Treasury Department plans to auction $8 billion in 30-year indexed bonds. This will be the sixth auction the Treasury has held since the instrument's introduction in January 1997. All told, the department has auctioned $39 billion in these notes with maturity dates ranging from five to 10 years. To date, primary buyers have been institutional investors such as insurance companies, as well as individuals.