Felix Salmon

What about perpetual TIPS?

By Felix Salmon
August 27, 2010

Eddy Elfenbein thinks the time is right for the U.S. government to issue perpetual bonds:

I say let’s float some Treasury perpetuities… say that these perpetuities aren’t callable for the next, say, 50 years. We could even call them “Obama Bonds.” I wouldn’t be surprised if we could lock-in 4%.

I wouldn’t be surprised either. Perpetual bonds are extremely convex, and investors like that. And of course there’s no reinvestment risk.

But the really valuable new instrument, I think, would be perpetual TIPS. Each one would pay a coupon of, say, $10 a month, indexed to inflation. If that 4% yield on nominal perpetual bonds is split into 2% time value of money and 2% expected inflation, then you’d expect one of these bonds, paying $120 per year in 2010 dollars forever, to cost about $6,000.

In other words, if you wanted to lock in an annual income of $60,000 which was guaranteed to rise with inflation, you’d need to pay $3 million up front. At any point, of course, you could sell your bonds to someone else: they’d fluctuate in value, to be sure, but chances are that they wouldn’t fluctuate that much. Long-duration bonds rise and fall a lot in value according to prevailing interest rates, but the main reason why long-term interest rates change is changes in long-term inflation expectations. Once those are stripped out, as they would be in perpetual TIPS, what’s left is relatively stable, in terms of its market value. To a first approximation, the value of the bond would rise in line with inflation.

Better yet, to a second approximation, the bonds would be countercyclical. They would become less attractive, and cheaper, when stocks are booming and interest rates are relatively high — just when the rest of your portfolio is likely to be doing very well. And their value would rise in times of bearishness, when most other markets were falling.

The bonds would be a great way of providing a reliable lifetime income — although of course since they would rise with inflation rather than with wages, the quality of life they buy would probably fall slowly over time. They could also provide a very handy benchmark against which to judge annuity products. On the other hand, they could worry a lot of people saving for retirement. I need $3 million to buy myself an income of $5,000 a month? That’s a scary prospect, to be sure.

14 comments so far | RSS Comments RSS

“I need $3 million to buy myself an income of $5,000 a month? ”

Err, no. For in retirement, or with an annuity, you eat your capital.

With a perpetual of course you’re not doing that. You need $3 million to give you $5,000 a month, and one of your children $5,000 a month after your death, and one of your grandchildren $5,000 a month after your child’s death….well, you get the picture.

Posted by TimWorstall | Report as abusive

Thank you, Tim, you got my point up first. That $3 million is still there when you die, for your heirs. Makes a big difference in the sticker shock issue.

Posted by kspb | Report as abusive

I think you underestimate the real return risk that a perp TIP would face. A 100 b.p increase in the real rate for your example would drop the price by a third. The duration on these would be pretty high.

Perhaps a better solution is one promoted by Zvi Bodie, which is target date matched TIPs portfolios which have the same duration as your retirement holding period. Because such portfolios would be immunized against any real rate changes, they would be as close to risk free as you can get.

Great blog by the way.

Posted by gatorbrit | Report as abusive

I think that’s a great idea, Felix. The nice thing about consols is perfect fungibility. The market for index-linked bonds is so much thinner than for nominal bonds, anything that reduces the number of outstanding issues would be good. Most of the structural interest is at the long end anyway. And unlike nominal consols, you wouldn’t have the problem of declining value requiring periodic consolidation of holdings.

Posted by Greycap | Report as abusive

It is not entirely accurate to say ” And of course there’s no reinvestment risk”. How about the coupon payment?

Posted by BahM | Report as abusive

Perpetual TIPS are almost the same as Trills. Much as I have argued for more long Treasury debt issuance, no institution has liabilities longer than 100 years. Nothing lives forever on Earth, so to think that debts can is a mistake.

Posted by DavidMerkel | Report as abusive

“Long-duration bonds rise and fall a lot in value according to prevailing interest rates, but the main reason why long-term interest rates change is changes in long-term inflation expectations. Once those are stripped out, as they would be in perpetual TIPS, what’s left is relatively stable, in terms of its market value. To a first approximation, the value of the bond would rise in line with inflation.”

Is it not true that the value of TIPS is positively correlated with changes in expected inflation? If long-term inflation expectations were to plummet, wouldn’t TIPS–particularly perpetual TIPS–do the same?

Posted by drzaius7734 | Report as abusive

You are correct @drzaius7734. If CPI turned negative (see Japan), the principal of your TIPS perpetuity is reduced by half the annualized change of CPI every 6 months. If there was ever a deflation scare, the value of your bond would be reduced. In theory, your purchasing power would remain constant or increase based on the assumption that CPI overstates inflation.

Posted by MRLAMF | Report as abusive

David Merkel — I don’t think perpetual TIPS are nearly as volatile, on a price basis, as Trills. Not even close. And MRLAMF, there IS no principal on a perpetual TIPS. It’s just interest.

Posted by FelixSalmon | Report as abusive

The value of TIPs is *not* positively correlated with inflation. It is positively correlated with the spot market, because of break-even trades. Note that today, when expected inflation rose (and the bond market tanked), TIPs also sold off pretty sharply.

I love it when people opine about what makes the bond market change. Anyone who has actually traded and invested in these things knows that bonds are really a conspiracy by math geeks to control the world. They messed up big-time with CDOs. Even amateurs shied away. But Gov’t guaranteed inflation bonds? Now *there’s* a plot worthy of SPECTR.

Posted by Publius | Report as abusive

If we think there’s a bubble in bonds, we could try to sell zero-coupon perpetual bonds. Every bubble needs its example of undiluted lunacy.

Posted by dWj | Report as abusive

What a great idea. This whole premise would work to reduce the number of survivalists-wannabees who are perpetually worried about hyperinflation. Many would feel confident in buying perpetual TIPS–it eliminates the worry of really high future inflation.

On the other hand, perpetual TIP’s would not appeal to the real bunker-mentality people, based on the risk of default, or even the dissolution of the U.S. And I don’t necessarily disagree with them in the very long term.

The Fed could make these bonds pretty useless if they engineered a stealth inflation (check the volume of a Bruyer’s ice cream box over the last 10 years, or how much cereal you actually get in the oversized box).

I would guess that the issuance of a large amount of TIP’s would be engineered by the CBO and NBER to understate inflation (just like the stats were rigged to understate unemployment right now). If the government used the same baselines and tools as they did in 1935, our actual unemployment numbers would hover around 20% rather than the current 9.5%.

There is virtually no limit as to how the government decides what to include, make up, or dis-include in various indexes. This could adversely affect the inflation portion of TIP’s. And I don’t see any adequate legal remedy to prevent the manipulation of government statistical “official” numbers.

A Supreme Court challenge on governmental statistical measures would likely fail for “lack of standing”.

So there is nothing out there to prevent a perpetual TIP’s buyer to object to the official figures indicating what they should be paid.

Still, there may be a place for these investments–so long as the holders realize that “perpetual” is illusory. I have heard that at 1 A.D., and investment in a small amount of gold, if untouched would grow to equal the entire output of our planet at a 5% assumed appreciated, compounded interest rate. Obviously, human institutions would eventually conspire to destroy that wealth over the long, or very-long term.

Posted by TaxLawyer | Report as abusive

Hmmmm. An ounce of gold at 1 AD is now worth more than the entire planet. Even if given as a gift? Perhaps 30 pieces of silver, at around 30 AD, would have an even greater value…

Posted by Publius | Report as abusive

Of course there is principal, or else, what are you loaning the government (or whoever for that matter)? The principal is the original loan and it is used to compute the coupon payments.

Posted by MRLAMF | Report as abusive

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