January 22, 1997

Trading in Inflation-Indexed Bonds Is Brisk

By ROBERT HURTADO

NEW YORK -- Inflation-indexed bonds began trading at surprisingly high prices and low yields Tuesday as the treasury department announced plans for its first auction ever of such securities, to be held next Wednesday.

The "real" yield on the bonds -- the interest rate to be paid over the rate of inflation as measured by the Consumer Price Index -- traded as low as 3.27 percent and ended the day at 3.32 percent.

"I'm a little surprised at how well they have been bid," said Donald Ross, director of fixed-income investments at the National City Bank in Cleveland.

The announcement of terms for the auction of 10-year inflation-indexed Treasury notes came on a day when the conventional Treasury bond market overcame early jitters to rally as the Federal Reserve Board chairman, Alan Greenspan, testified in Washington on the state of the economy.

The yield on the benchmark 30-year Treasury bond fell to 6.78 percent from 6.83 percent on Friday. The bond market was closed on Monday for the Martin Luther King Jr. holiday.

The expectation by many in the market had been that the new inflation-indexed bonds would trade in a range of 3.5 percent to 3.75 percent. And the first trade, after terms were announced at noon, was at 3.55 percent, traders said. But then they fell.

The trades were on a when-issued basis, meaning they will be concluded only after the bonds are issued. And traders noted that when-issued trading was often volatile and might not completely reflect investor demand for the new securities.

"The initial market action indicates there is demand for the bonds," said Dan Bernstein of Bridgewater Associates. "The question is how representative it is."

The Treasury said $7 billion of the bonds would be auctioned, in the first of quarterly auctions.

An investor will get a smaller coupon payment than is available on a normal 10-year Treasury note. Were the initial auction rate to be 3.50 percent, the investor would get a payment of $175 twice a year on a $1,000 bond. By contrast, the yield on normal 10-year Treasuries now is 6.50 percent, for a semiannual payment on a new issue of $325.

But a buyer of the new inflation-protected bonds will see his principal rise each six months, by the amount of inflation. That will raise the amount of each semiannual interest payment, since it will be based on the higher figure, and will mean the investor gets more money at the end, when the bond matures.

The new 10-year notes will be auctioned four times a year in denominations as small as $1,000. The new bonds will be auctioned in a single-price format like the two-year and five-year notes being sold this week. Then the notes will be awarded at the highest yield needed to sell all the securities, called a Dutch auction.

The new securities are expected to be attractive to individuals in retirement accounts and to such institutional investors as pension funds and endowments.

Similar inflation-indexed securities now trade in several other countries, providing substantially higher real yields than are indicated by the initial trading Tuesday. Ray Dalio of Bridgewater Associates said similar securities in Canada had a real yield of about 4.25 percent, while those in Britain brought a real yield of almost 3.5 percent.

The rally in the bond market came as Greenspan testified before the Senate Budget Committee. "Despite his assessment that the labor markets are exceptionally tight," said Anthony Chan, chief economist at Banc One Investment Advisers, "he indicated that the Fed didn't feel compelled to automatically tighten simply because the labor market was tight,"

Chan added that investors took hope that something else would come up to alleviate the need for the Fed to raise rates, such as indications of a higher savings rate or movement in Washington toward a balanced budget.

The results of Tuesday's weekly bill auction were much as expected, with rates mixed, even though the six-month issue did see some strong bidding. The average discount rate for a three-month bill was 5.03 percent, down from 5.04 percent last week, with the discount rate for a six-month bill at 5.11 percent, unchanged from a week ago.

On Wednesday the Treasury plans to offer $17.5 billion of new two-year notes, and on Thursday $12.5 billion of five-year notes. In when-issued trading the two-year note was being offered at a price to yield 5.99 percent, and the five-year for sale on Thursday was offered at a price to yield 6.29 percent.