Investors Pour Into New ‘Inflation’ Notes

The U.S. Treasury’s first-ever offering of bonds designed to protect investors from the ravages of inflation was a huge hit Wednesday, as buyers placed bids for $37.2 billion of the securities--five times the amount offered.

The Treasury auctioned $7 billion of 10-year inflation-indexed notes at an annualized fixed yield of 3.449%, and by the end of trading the yield was down to 3.38%--a further indication of the robust demand for the securities.

But many bond market veterans said they were unsure whether the flurry of bidding by Wall Street institutions was a sign that inflation fears are rising. Some institutions may simply have been eager to have the notes on hand to offer clients, or were buying merely to be able to “flip” the securities at a profit in the short term.

“It’s hard to know [in whose hands] these notes will finally end up,” said David Schroeder, a bond fund manager at American Century Benham in Mountain View, Calif.

The Treasury will protect note owners against inflation by increasing the notes’ principal value each year by the rise in the consumer price index. Thus, the 3.449% yield on the notes constitutes a guaranteed “real,” or after-inflation, return.

In contrast, the fixed annual yield on standard 10-year Treasury notes currently is 6.62%, but the notes’ principal isn’t adjusted for inflation. So the inflation rate must be subtracted from that yield to show what investors really earn.

If inflation is 3.3% in 1997--the same rate as 1996--the real yield on a standard 10-year T-note would be 3.32%, slightly below the 3.449% yield on the new notes.

Of course, the bigger question is what inflation will be over the next 10 years. If it declines, standard T-notes could potentially produce bigger real returns. If inflation soars, however, the new notes’ guaranteed real return of 3.449% will obviously be more appealing.

For the Treasury, the notes offer a way to cut current interest costs. But if inflation soars, the notes could cost the Treasury far more over time than standard notes.

Treasury Secretary Robert Rubin on Wednesday declared the yield on the new notes, which was determined by investors’ competitive bidding, was “a very fair rate, both for the buyers and the seller.”

Economists believe one important use of the new notes will be as an inflation bellwether: If demand for them is heavy, it would suggest investors expect rising inflation.

But experts said the novelty of the first offering Wednesday probably attracted many institutional buyers that aren’t necessarily worried about inflation.

Even so, Scott Grannis, economist at Western Asset Management in Pasadena, said the 3.449% real return--higher than what standard notes offer--”tells you people are skeptical about inflation staying low.”

Most of the buyers Wednesday were institutions. Individuals bid noncompetitively for just $157 million of the notes. William Gross, principal at bond fund giant Pimco Advisers in Newport Beach, said his firm got just $100 million of the notes and wanted much more. He said the notes were attractive as a capital-preservation tool and because their real return “beats almost everything” in the Treasury market except 30-year bonds.

Traders said there were rumors that China bid for $1 billion of the notes.