Debt Management: Treasury Inflation Protected Securities Should Play a Heightened Role in Addressing Debt Management Challenges
Published: 2009-09-29T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The 2008 financial market crisis and the economic recession led to a rapid and substantial increase in federal debt. This report, part of a line of work on debt management, was conducted under the Comptroller General's authority. It describes current debt management challenges and examines the role of a program that could benefit Treasury--Treasury Inflation Protected Securities (TIPS). GAO analyzed market data and interviewed experts as well as the two largest holders of Treasury securities in each of six sectors.
section_title: What GAO Found
paragraphs: In January 1997, Treasury introduced an inflation-indexed security--TIPS. Treasury's stated objectives were to both raise the national savings rate and to reduce the federal government's cost of borrowing. TIPS offer inflation protection to investors who are willing to pay a premium for this protection in the form of a lower interest rate. In a functioning TIPS market, the difference between the interest rate on nominal Treasury securities and the interest rate on TIPS is expected to be approximately equal to the expected inflation rate. Federal government actions in response to both the financial market crisis and the economic recession have added significantly to Treasury's borrowing needs. Since the onset of the recession in December 2007, Treasury has borrowed more than $2.3 trillion, largely by issuing short-term nominal debt, which significantly changed the composition of Treasury's debt portfolio. The challenges presented by increasing debt and the change in its composition take place in the context of the medium and longer term fiscal outlook and will not recede with the return of financial market stability and economic growth. The Congressional Budget Office (CBO) projects that, absent changes in current policy, debt held by the public will double in 5 years (from 2008 to 2013) and almost triple in 11 years (from 2008 to 2019)--reaching 82 percent of GDP. In order to meet these challenges Treasury needs to diversify its funding sources and lengthen the term-to-maturity of its debt portfolio. TIPS can contribute to this effort. Treasury's TIPS program has had varying degrees of liquidity (the ease with which investors can trade the security) since its inception. The major institutional investors that GAO interviewed perceived Treasury's commitment to the TIPS program as having wavered in recent years, decreasing the liquidity of TIPS in the market. Investors demand a premium for holding less-liquid TIPS, which increases Treasury's borrowing costs. TIPS offer benefits to Treasury and measuring the cost against which to weigh these benefits requires both forward-looking and after-the-fact analysis. A more robust TIPS program could benefit Treasury by diversifying and expanding its funding sources and reducing the cost of nominal securities. Governments are well suited to bear inflation risk because periods of inflation are often associated with increased revenues. TIPS auctions also help provide a measure of market inflation expectations. On July 1, 2009, GAO briefed Treasury's Office of Debt Management on the findings from our analysis and interviews with major institutional investors. Treasury later posed questions about ways to improve the TIPS program to the Primary Dealers and the Treasury Borrowing Advisory Committee (TBAC). At the August 2009 TBAC meeting, members discussed TIPS. Following the meeting, Treasury's Deputy Assistant Secretary for Federal Finance reaffirmed Treasury's commitment to TIPS and announced plans to gradually increase issuance of TIPS.

section_title: Letter
paragraphs: Between December 2007 and the end of June 2009, the Department of the  Treasury borrowed more than $2.3 trillion to finance federal government  actions related to both the financial market crisis and the economic  recession in addition to regular government financing needs. This rapid  and substantial increase in federal debt takes place in the context of the  medium- and long-term fiscal outlook that will present Treasury with  continued financing challenges long after the return of financial stability  and economic growth. GAO has begun a line of work related to Treasury’s  management of its growing debt portfolio. As part of this ongoing work,  we will continue to provide updates and make recommendations as  appropriate.
In this first report, conducted under the Comptroller General’s authority,  we describe Treasury’s borrowing challenges and analyze one Treasury  program that has the potential to provide benefits to both Treasury and  investors—Treasury Inflation Protected Securities (TIPS). We address the  following questions:    What are the debt management challenges associated with planning for  future borrowing needs given the long-term fiscal outlook and  Treasury’s increased borrowing due to economic and financial sector  stress?
What role, if any, should TIPS play in Treasury’s borrowing program?
subsections: section_title: Background
paragraphs: Congress has assigned to Treasury the responsibility of borrowing the  funds necessary to finance the gap between cash-in and cash-out, subject  to a statutory limit. Treasury’s primary debt management goal is to finance  the government’s borrowing needs at the lowest cost over time. Issuing  debt predictably through regularly scheduled auctions lowers borrowing  costs because investors and dealers value liquidity and certainty of supply.  Treasury responds to increases in borrowing needs in a traditional  manner, by first increasing the issuance size of existing securities; then,  increasing the frequency of issuances; and finally, introducing new  securities to its auction calendar as necessary.
Treasury normally auctions nominal marketable securities that range in  maturity from 4 weeks to 30 years and sells them at auction on a pre- announced schedule. Treasury also issues cash management bills that are  not part of the regular schedule to meet immediate cash needs. Treasury  securities are widely viewed as the premium risk-free asset and are  actively used by investors, traders, and foreign central banks for hedging,  liquidity, and reserve purposes. The outstanding mix of U.S. Treasury  securities can have a significant influence on the federal government’s  interest payments. Longer term securities typically carry higher interest  rates (which translate to increased cost to the government), primarily due  to concerns about future inflation. However, these longer term securities  offer the government the certainty of fixing the interest payments over a  longer period and reduce the amount of debt that Treasury needs to  refinance in the short term. In contrast, shorter term securities generally  carry lower interest rates but add volatility to the government’s interest  costs and require Treasury to conduct more frequent auctions to refinance  maturing debt.
During the 1980s and 1990s, a number of countries introduced inflation- indexed securities to their debt offerings, including the United Kingdom,  France, and the United States. In January 1997, Treasury introduced its  own inflation-indexed securities, TIPS, as part of its debt program. At the  time, Treasury’s stated objectives for introducing TIPS were both to raise  the national savings rate and to reduce the federal government’s cost of  borrowing. TIPS offer inflation protection to investors who are willing to  pay a premium for this protection in the form of a lower interest rate. In a  functioning TIPS market, the difference between the interest rate on  nominal Treasury securities and the interest rate on TIPS should  approximately equal the expected inflation rate. Treasury currently issues  5-, 10-, and 20-year TIPS. In the past, Treasury issued 30-year TIPS, but  discontinued them in 2001. See appendix I for additional details on the  structure of TIPS.
section_title: Scope and Methodology
paragraphs: To identify the debt management challenges associated with Treasury’s  increased borrowing, we analyzed the scale, timing, term to maturity, and  composition of Treasury’s borrowing since the start of the economic  recession, using data and information obtained from the Department of  the Treasury and the Federal Reserve. We also interviewed market  experts, Treasury, and Federal Reserve staff and officials.
To examine what role TIPS should play in Treasury’s debt portfolio and  the potential for the TIPS program to help address Treasury’s debt  management challenges, we conducted literature reviews on the costs and  benefits of inflation-indexed securities and examined research by Federal  Reserve economists, market experts, academic sources, and the  Department of the Treasury, including an internal review of the TIPS  program done by the Office of Debt Management (ODM). We also  conducted 12 structured interviews in June 2009 with the two largest  holders of Treasury securities in each of the following sectors: mutual  funds; commercial banks; life insurance companies; property and casualty  insurance companies; state and local pension funds; and private pension  funds. The major institutional investors we interviewed held at least $351  billion in Treasury securities. Of their Treasury holdings, $99.4 billion were  TIPS, which was 19 percent of total outstanding TIPS as of March 31, 2009.  These interviews covered the institution’s holdings of Treasury securities,  demand for TIPS, changes that could be made to the TIPS program,  perceived risks to investors in Treasury markets, and Treasury’s sources  for information on demand for Treasury securities. On July 1, 2009, we  briefed Treasury’s ODM on the findings from the structured interviews,  which are discussed and expanded upon in this report.
Where possible and appropriate, we corroborated the results of our data  analyses and interviews with other sources. On the basis of our  assessment we believe that the data are reliable for the purposes of our  review. We conducted our review from June 2009 through August 2009 in  accordance with generally accepted government auditing standards. Those  standards require that we plan and perform the audit to obtain sufficient,  appropriate evidence to provide a reasonable basis for our findings and  conclusions based on our audit objectives. We believe that the evidence  obtained provides a reasonable basis for our findings and conclusions  based on our audit objectives.
section_title: Size and Composition of Treasury’s Debt Profile Has Changed Substantially
paragraphs: Treasury faces two near-term challenges in managing the growing  government debt: the rise in total outstanding debt and the shortening of  the average maturity of the debt profile. Treasury’s total outstanding debt  increased by $2.3 trillion (25 percent increase in federal debt) since the  onset of the economic recession in December 2007. In actions Treasury  described as in accordance with normal operating procedures, Treasury  increased short-term borrowing to address its massive and immediate  borrowing needs. As a result, the average maturity of Treasury’s debt  decreased as the percentage of marketable debt maturing within 1 year  increased from 35.6 percent to 41.1 percent between September 2007 and  June 2009. At the end of June 2009, Treasury’s outstanding marketable  securities stood at $6.6 trillion, an increase of almost $2.1 trillion from  December 2007. The largest increase in outstanding marketable Treasury  securities was in short-term debt. Treasury bill and cash management bill  issuance increased by a combined $1 trillion between December 2007 and  June 2009. The amount of Treasury notes issued also increased  significantly over this period, adding $929.3 billion to the amount of notes  outstanding. Almost half of the increase was comprised of shorter-term  notes (with 2-year and 5-year maturities). The monthly issuance of 2-year  notes alone has almost doubled in the last 2 years. Figure 1 shows the  relative size of the increases in different categories of securities. The  smallest increase was in TIPS which increased by $60.6 billion.
Treasury has raised significant amounts of cash since the onset of the  economic recession in December 2007 largely by adhering to its regular  and predictable debt issuance schedule, which is meant to ensure the  lowest borrowing costs over time. However, Treasury has also turned to  issuing cash management bills, which are announced shortly before  auction to fulfill Treasury’s immediate cash needs. After the financial  market crisis hit in fall of 2008, Treasury raised an unprecedented $1.1  trillion in under 18 weeks largely by issuing cash management bills.  Treasury was able to finance such an amount due in part to outsized  demand among global investors for a safe and liquid financial instrument  in the midst of the contraction in global economic activity.
As shown in figure 2, 78 percent (or about $5.1 trillion) of the outstanding  marketable Treasuries mature by 2015 and will need to be rolled over (or  refinanced)—potentially at higher interest rates. Because short-term rates  have been reduced sharply by the decision of the Federal Reserve to set its  federal funds target near zero, Treasury’s borrowing costs decreased even  though debt levels increased. (See figure 3.) However, projections from  both the Congressional Budget Office (CBO) and Office of Management  and Budget (OMB) assume higher interest rates and higher interest  payments. CBO’s analysis of the President’s Budgetary Proposals for  Fiscal Year 2010 assumed that interest rates on 91-day Treasury bills  would increase from 0.3 percent in 2009 to 4.7 percent in 2015 and that  interest on 10-year Treasury notes would increase from 2.9 percent to 5.4  percent over the same period. CBO’s analysis of the President’s Budgetary  Proposals for Fiscal Year 2010 shows—absent changes in policy—interest  payments on federal debt more than tripling—to almost $800 billion—by  2019. (See figure 3.)
See Congressional Budget Office, An Analysis of the President’s Budgetary Proposals for  Fiscal Year 2010 (Washington, D.C.: June 2009). gradually transition the portfolio into longer term debt. They also told us  that, given the need to be flexible operationally, Treasury’s debt  management horizon is shorter than the horizon used by CBO and OMB in  budget projections and that they are confident about their ability to  finance the projected budget deficits for 2010 and 2011.
subsections: section_title: Fiscal Outlook Will Present Continued Debt Management Challenges
paragraphs: As noted, the federal government’s policy response to the financial market  crisis and the economic recession created a significant increase in both  debt and debt management challenges. These will not recede when  stability returns to financial markets and economic growth resumes. CBO  projects that, absent changes in current policy, the debt held by the public  will double in 5 years (from 2008 to 2013) and almost triple in 11 years  (from 2008 to 2019). (See figure 4.) CBO projects that debt held by the  public will increase from 41 percent of gross domestic product (GDP) in  fiscal year 2008 to 71 percent by the end of fiscal year 2013.
The actions that Treasury has taken to increase borrowing in response to  the economic recession and financial market crisis take place within the  context of the already serious longer term fiscal condition of the federal  government. While the administration and Congress have been  understandably focused on addressing problems with financial markets  and responding to the economic recession, the government will need to  apply the same level of intensity to the nation’s long-term fiscal challenge.  Both our long-term simulations and CBO’s show growing deficits and debt,  underscoring that the long-term fiscal outlook is unsustainable. Under our  alternative simulation, by 2025 debt held by the public would exceed the  historical high of 109 percent of GDP, reached in the aftermath of World  War II. (See figure 5.)
The deterioration in the short-term and long-term budget outlooks,  combined with expenditures associated with the Troubled Asset Relief  Program (TARP) and Recovery Act spending, will likely continue to stress  the existing auction schedule. Treasury has already begun to respond by  adjusting the auction schedule so that they can conduct more auctions of  increasingly larger amounts, while simultaneously minimizing borrowing  costs over the long term.
According to the major institutional investors that we interviewed, the  best days of the week for Treasury to conduct auctions are Tuesday,  Wednesday, and Thursday. However, Treasury is facing an increasingly  crowded borrowing schedule, often with multiple auctions in a single day.  For example, during the week of July 27, 2009, Treasury held eight  auctions, issuing close to $272 billion in securities in one week and holding  multiple auctions on two of those days. In addition, Treasury has been  forced to hold and plan auctions on days that it has tried to avoid in the  past, such as days of major Federal Reserve announcements. Holding  auctions on these days increases uncertainty for auction participants.
Market experts believe that the large amount of the debt that must be  rolled over in the next few years is cause for concern and agree with  Treasury that it needs to increase the average maturity of its debt portfolio  and diversify its funding sources. Large and growing borrowing needs put  a premium on better understanding current and future demand for  Treasury securities. Two securities that Treasury can currently use to  reduce the amount of securities that are rolling over in the next 10 years  are 30-year nominal bonds and 20-year TIPS. Treasury has already  increased the frequency of the issuance of 30-year bonds; first it reopened  the 30-year bond in February 2009 and then added a second reopening in  May 2009, effectively issuing the 30-year bond on a monthly basis.  Treasury should continue to consider options to lengthen its maturity  profile to mitigate the risks mentioned above. Longer-dated TIPS offer one  option. The 30-year TIPS was discontinued along with the 30-year nominal  bond in October 2001, but only the 30-year nominal bond was  reintroduced. The 20-year TIPS, is currently issued only twice a year, but  its record as a low-cost funding source has been mixed in part due to a  lack of liquidity as explained in the next section.
section_title: Treasury’s TIPS Program Has Had Varying Degrees of Liquidity Since Inception and Major Institutional Investors Have Expressed Concern about Treasury’s Commitment to the Program
paragraphs: Treasury’s TIPS program has had varying degrees of liquidity since its  inception in 1997. Liquidity is a measure of the ease with which investors  can trade a security. Liquidity is important to Treasury because liquid  securities can be auctioned at lower rates, and thus cost Treasury less  money.
The difference between the breakeven inflation rate—the interest rate on a  nominal security minus the interest rate on a comparable-maturity TIPS— and a measure of expected inflation can be used to evaluate the ex-ante  cost of nominal securities relative to TIPS. When this difference is  positive, nominal securities cost more than TIPS; when it is negative, TIPS  cost more than nominal securities; and when the difference is zero, the  cost is approximately equivalent. Two primary factors affect this  difference. The first is the illiquidity premium associated with TIPS, which  raises the interest rate on TIPS relative to nominal securities. The second  is the inflation risk premium, which is the insurance value that investors  attach to TIPS’ protection against inflation. The inflation risk premium  reduces the interest rate on TIPS relative to the rate on nominal securities.  To the degree that the inflation risk premium and illiquidity premium are  roughly equal, nominal Treasury securities and TIPS of the same maturity  would cost about the same, on an ex-ante (or before the fact) basis. For a  more detailed discussion on calculating the cost of TIPS compared to  nominal securities see appendix II.
In 1997, when the TIPS program was launched, the initial auctions were  well-received by investors, with robust bid-to-cover ratios. As seen in  figure 6, the average 10-year breakeven rate minus expected inflation in  1997 was the largest seen to date on the 10-year TIPS. Thereafter, from  1998 until about 2004, TIPS liquidity remained relatively poor and the  gross amount issued by Treasury decreased from 1998 to 2000.
Starting in 2002, Treasury sought input from market participants on how  to improve the TIPS program and made a number of changes to the  program. Specifically, Treasury increased the amount issued at auction  and increased the frequency and range of TIPS offerings. In addition,  Treasury made a number of speeches and official statements to reaffirm  its commitment to the program and to indicate its dedication to improving  TIPS liquidity. Some of the major institutional investors we interviewed  observed that these efforts improved investor confidence in the program  and ultimately improved the liquidity of TIPS. As seen in figure 6, from  2004 to 2007, the difference between the average 10-year breakeven rate  and inflation expectations was positive or near zero, meaning the TIPS  illiquidity premium was approximately equal to the inflation risk premium  of nominal securities and indicating that TIPS liquidity improved over that  period.
More recently, from 2006 to 2008, Treasury reduced the gross amount of  TIPS issuance by 19 percent. The major institutional investors that we  interviewed also perceived that during this time, Treasury’s commitment  to the TIPS program began to wane, communicating uncertainty about the  program’s future. These investors believed that the uncertainty  surrounding TIPS hurt TIPS liquidity in the secondary market.
In the period following the 2008 financial market crisis, TIPS liquidity  further deteriorated as demand for the more liquid nominal Treasury  securities soared. The illiquidity premium, or the extra compensation that  Treasury has to pay investors to hold TIPS, may have increased during the  financial crisis due to the increased difficulty of selling holdings of TIPS in  the secondary market during that time. Major institutional investors whom  we interviewed reported uncertainty about Treasury’s commitment to the  TIPS program and suggested increased issuance and positive signaling to  improve the liquidity of TIPS, thereby reducing the cost of the program to  Treasury.
subsections: section_title: Major Institutional Investors Report Uncertainty about Treasury’s Commitment to TIPS and Suggest Increased Issuance and Positive Signaling to Improve the Liquidity of TIPS
paragraphs: Interviews with major institutional investors revealed uncertainty about  Treasury’s commitment to TIPS. The investors pointed to the 19 percent  decline in TIPS gross issuance amounts, along with Treasury’s tepid  signaling on TIPS, as fueling speculation about the future of the program.  (See figure 6.) As of June 2009, TIPS made up about 8 percent of total  outstanding marketable Treasury securities, compared to 10 percent in  September 2007 and 2008.
As we reported to Treasury, on July 1, 2009, there was agreement among  the major institutional investors whom we interviewed that Treasury could  improve liquidity in the TIPS market by signaling to the market its  commitment to the program and by increasing issuance. Investors  suggested that Treasury repeat efforts to promote the TIPS program as  they did from 2002 to 2004. Investors told us that increasing the issuance  amount at auction or increasing the frequency of auctions would have a  similar signaling effect and the additional supply would also improve  liquidity in the secondary market. Most of the investors replied that they  planned to purchase TIPS in the next year; interest in the 10-year TIPS was  mentioned most frequently. Some investors stated that their organizations  would be more likely to participate in the TIPS market if the supply of  securities was greater and auctions were conducted more frequently.  Some investors reported wanting to make larger TIPS purchases than was  possible in the secondary market and also that the long wait between TIPS  auctions sometimes did not align with their investment needs. Currently,  there is a 6-month wait between auctions for 5-year and 20-year TIPS and a  3-month wait between auctions for 10-year TIPS.
At our briefing, Treasury’s Director of ODM and ODM staff told us that if it  were to expand the TIPS program, Treasury would face increased  exposure to auction risk due to the current concentration of bidders at  auction and the resulting possibility that there may not be enough bidders  to cover the auctioned amount. But Treasury already has policies in place  to ensure that potentially undersubscribed auctions are sufficiently  covered. In addition to these policies, investors we interviewed told us  that a more formalized line of communication between Treasury and end- users could enable Treasury to better gauge market demand. We are in the  process of surveying investors on what actions Treasury could take to  increase participation in TIPS auctions and improve communication with  end-users of Treasury securities.
One indicator used to measure demand at a Treasury auction is the bid-to- cover ratio, which compares the dollars bid to the dollars accepted at a  Treasury auction. If the ratio is high, it indicates strong demand for a  particular Treasury security at auction. There is historical evidence that  auctions in the TIPS market have bid-to-cover ratios only slightly lower  than the more robust market for nominal securities. As shown in figure 7,  for most of the period prior to 2009, TIPS auctions had slightly lower bid- to-cover ratios than comparable nominal securities. But more recently,  differences between TIPS and nominal bid-to-cover ratios have decreased.  From January to July of 2009, the average bid-to-cover ratio for 5-, 10-, and  30-year nominal auctions has been 2.30. The average bid-to-cover ratio of  5-, 10-, and 20-year TIPS auctions has been 2.31 during the same period.
Treasury’s current policies to ensure sufficient coverage of auctions were  instituted after a 10-year nominal Treasury note auction had a relatively  low bid-to-cover ratio of 1.2 in May 2003. The more recent, stronger bid-to- cover ratios indicate that the market would support increased TIPS  issuance. A more liquid TIPS market would benefit Treasury. At the same  time, the cost to Treasury of the TIPS program going forward remains a  subject of debate.
section_title: TIPS Program Offers Benefits to Treasury, and Measuring Its Cost Requires both Forward-Looking and After-the-Fact Analysis
paragraphs: TIPS offer a variety of benefits to both Treasury and investors. TIPS  provide Treasury the opportunity to diversify its investor base because  TIPS are by design a very different product than nominal securities. In  addition, TIPS may reduce the cost of nominal securities. The cost against  which to weigh the benefits of TIPS, however, is unclear. While there is  agreement on the higher initial cost of the TIPS program, less consensus  exists on the total cost of the TIPS program to date.
subsections: section_title: TIPS Program Could Benefit Treasury by Diversifying Its Funding Sources and Investor Base
paragraphs: TIPS could benefit Treasury by diversifying its funding sources and  investor base. Market experts and researchers, including the Securities  Industry and Financial Markets Association (SIFMA), asserted that TIPS  could provide Treasury with access to new investors whose needs could  complement those of investors in nominal securities. In a 2004 letter to  Treasury, the Bond Market Association, now part of SIFMA, stated that  “the Association continues to believe that the Treasury’s TIPS program is  likely to ultimately help reduce Treasury’s overall cost of funding by  attracting a new pool of investors and facilitate better liability  management.”
There is direct evidence that TIPS could help Treasury access different  groups of investors. According to research by a New York Federal  Reserve expert on Treasury markets, between July 30, 2001, and  December 28, 2005, investment funds (which included mutual funds and  hedge funds) accounted for 30.2 percent of TIPS sold at auction, but only  11.5 percent of nominal notes and bonds. Whereas, between July 30,  2001, and December 28, 2005, the largest group of Treasury holders,  foreign and international investors, accounted for 8.2 percent of TIPS sold  at auction and 21.1 percent of nominal notes and bonds. Another example  of the diversification that TIPS could provide is that pension funds tend to  purchase a higher share of TIPS securities than nominal Treasury  securities at auctions.
While TIPS auctions have been highly concentrated, with just a few  regular participants, TIPS may exhibit less ownership concentration than  nominal securities. As of December 2008, the largest TIPS fund (Vanguard  Inflation-Protected Securities Fund) reported $16.6 billion in TIPS  holdings, accounting for 3.1 percent of the $530 billion in TIPS outstanding  on that date. In contrast, Treasury International Capital data shows that  the largest foreign holder of U.S. Treasury securities (China) reported $727  billion, accounting for 12.5 percent of the $5.8 trillion in total marketable  Treasury securities on the same date.
One indicator of TIPS’ potential to diversify funding sources for Treasury  is the growth of inflation-protected mutual funds. Both the number and the  amount of assets under management in inflation-protected funds have  increased since 2002. As seen in figure 8, the number of inflation-protected  funds doubled from 20 at the end of December 2002 to 40 at the end of  May 2009. The amounts of inflation-protected funds under management  increased from $11.8 billion to $54.4 billion during the same period. The  mutual fund managers that we interviewed expressed their investors’  continued interest in the TIPS program going forward and plan to continue  to purchase TIPS securities over the next year. According to data from one  large mutual fund company, between 2003 and 2008 the large majority of  inflows into its TIPS fund came from non-Treasury funds.
According to market experts, another potential benefit of the TIPS  program to Treasury is its potential to reduce government borrowing  costs. If Treasury has to increase the supply of nominal securities  substantially to fund larger deficits, it may need to raise yields in order to  attract enough buyers due to the saturation of the nominal Treasury  market. Therefore, issuing TIPS may make sense as a substantial shift in  the composition of Treasury issuance into TIPS from nominal Treasuries  could lead to lower interest rates paid on the remaining nominal Treasury  issuance. This argument has been cited as a benefit by a number of market  experts, but additional research is required. Treasury’s access to auction  data puts ODM staff in a unique position to conduct a comprehensive and  ongoing analysis of the impact that TIPS have on the cost of nominal  securities. In commenting on this report, Treasury told us that ODM staff  have reviewed such data. They note that TIPS have remained less liquid  than nominal securities and are considering approaches to improve the  inflation-indexed market.
Treasury securities have the potential to provide a number of social, fiscal,  and monetary benefits. All Treasury securities provide investors with  virtually zero credit risk. Only TIPS, however, provide zero inflation risk,  making them one of the most effective ways for risk-averse households to  meet their savings needs. In contrast, one of the downsides of nominal  Treasury securities is that in the event of unexpected inflation, the real  return to investors will be less than expected. Investors in nominal  Treasury securities assume the risk of inflation eroding their expected  return, but inflation-protected investments, such as TIPS, shift the inflation  risk to the issuer.
Economists have noted that governments are better able to bear inflation  risk because periods of inflation are often associated with increased  revenues. Economists have also noted that TIPS could make the Federal  government more accountable for the inflationary consequences of its  actions in the form of higher payments on TIPS, if inflation increases. The  results of TIPS auctions also provide useful information to policymakers  on inflation expectations. In this respect, TIPS auctions help provide a  measure of market inflation expectations, which can be taken into account  when making monetary policy decisions.
section_title: Forward-Looking Analysis of TIPS Program’s Costs Adds an Important Perspective to Evaluating the Role of TIPS as Part of Treasury’s Debt Portfolio
paragraphs: Ex-ante is Latin for beforehand. In models with uncertainty, ex-ante values are expected  values that are calculated before the uncertainty is resolved.
Ex-post is Latin for after the fact. In models with uncertainty, ex-post values are the  realized or actual values that are calculated after the uncertainty has been resolved.
In the context of nominal interest-bearing government securities, investors are assumed  to demand compensation for expected inflation. Ex-ante expectations about inflation are  assumed to be formed rationally, meaning that expectations will be identical to optimal  forecasts using all available information. Ex-post, realized inflation rates may differ from  ex-ante expected values, but these differences should not be systematically positive or  negative.
For a sufficiently lengthy time horizon the cost of TIPS relative to nominal Treasury  securities should be the same when calculated on both an ex-ante and ex-post basis, all  else equal. For shorter time horizons, the difference between expected and realized  inflation values may appear to be persistent; thus, the ex-ante approach may be  preferred to assess the cost of TIPS relative to nominal Treasury securities over the short  term.
Market experts have measured costs of TIPS in two primary ways. The  first approach evaluates TIPS on an ex-post (after the fact) basis. That is,  the cost of TIPS and nominal securities are compared based on what  inflation actually was during a given time period. Economists conducting  ex-post analyses have concluded that the TIPS program has been less cost- effective for Treasury than nominal securities. A 2008 study by a Federal  Reserve economist estimated that the total cost of the TIPS program  through October 2007 was between $4.5 billion and $7.5 billion. Based on  TIPS issued through July 2009, Treasury’s ODM estimated the total cost of  TIPS at $10 billion to date. This more recent study includes the anomalous  period characterized by the financial market crisis and the related flight to  quality which made nominal securities relatively inexpensive for Treasury.  Economists generally agree that part of the relatively higher cost of the  TIPS program can be attributed to its start-up costs. According to market  experts and the major institutional investors that we interviewed, other  factors that may have contributed to the relatively higher cost to Treasury  of the TIPS program to date are investors’ perceptions of Treasury’s lack  of commitment to the program and the relatively low inflation experienced  throughout the life of the program. Since the TIPS program was  introduced, the annual Consumer Price Index for All Urban Consumers  (CPI-U) percent change never exceeded 3.8 percent, which is low by  historical standards. The CPI-U averaged 7.08 percent and 5.55 percent  during the 1970s and 1980s, respectively.
In contrast, other economists who have studied the issue argue that from  an ex-ante (before the fact) basis, TIPS are not more costly to issue than  nominal securities and that the relative cost of the TIPS program to date in  part reflects start-up costs that will not be incurred again. One recent  study by Treasury’s ODM found that TIPS are not less costly when  measured on an ex-ante basis, but this study includes the anomalous  period characterized by the financial market crisis and the related flight to  quality which made nominal securities relatively inexpensive for Treasury.  Another ex-ante study, noted that if the TIPS program were as liquid as the  market for off-the-run nominal Treasuries, Treasury would have realized  total cost savings from the TIPS program of $22 billion to $32 billion.  Over the short run, economists recognize that an assessment of TIPS  program’s relative costs depends on whether Treasury or the investor is  the beneficiary from differences in expected and actual inflation. The time  horizon of the analysis affects the results since, over the long run, the  average amount by which actual inflation exceeds expected inflation will  roughly equal the average amount when the opposite is true. Therefore,  some market experts argue that TIPS should be evaluated on an ex-ante  basis, for example, by finding the difference between the breakeven  inflation rate (the nominal-TIPS yield differential) and a survey-based  measure of inflation expectations at the time of the TIPS auction. This  difference is independent of inflation surprises and provides a measure of  the net savings or loss incurred by Treasury.
section_title: Concluding Observations
paragraphs: Faced with the economic recession and the ensuing 2008 financial market  crisis, Treasury is to be commended for its success in raising  unprecedented amounts of cash in a very short amount of time. Absent  policy changes, the medium- and long-term fiscal outlook mean that  Treasury will need to raise increasing amounts of cash, and build  borrowing flexibility by increasing the term to maturity of its debt  portfolio, while retaining its focus on reducing its overall borrowing cost.  While questions remain about how to evaluate the cost of the TIPS  program, TIPS have the potential to provide Treasury with a number of  benefits and help Treasury achieve its debt management objectives.
On July 1, 2009, we briefed Treasury’s ODM on the findings from our  analysis and interviews with major institutional investors. Treasury later  posed questions about ways to improve the TIPS program to the Primary  Dealers and TBAC. At the August 2009 TBAC meeting, members discussed  TIPS. Following the meeting, Treasury’s Deputy Assistant Secretary for  Federal Finance reaffirmed Treasury’s commitment to TIPS and  announced plans to gradually increase issuance of TIPS.
section_title: Recommendations
paragraphs: The Secretary of the Treasury should take the following actions to  improve TIPS liquidity in the context of projected sustained increases in  federal debt:  increase TIPS issuance,  issue TIPS with longer-dated maturities, and    conduct more frequent TIPS auctions.
The Secretary should continually review the appropriate composition of  the TIPS program, and consider:  the impact of Treasury’s public statements and TIPS issuances on TIPS  liquidity,    how both ex-ante (before the fact) and ex-post (after the fact) analyses  are valuable for evaluating the cost of TIPS, recognizing the anomalous  nature of market data from periods such as the 2008 financial market  crisis,  the ways in which the TIPS program can diversify Treasury’s investor  base and funding sources, and  the degree to which TIPS impact the cost of nominal securities.
section_title: Agency Comments
paragraphs: We requested comments on a draft of this report from the Secretary of the  Treasury and received comments on behalf of the Treasury from its  Deputy Assistant Secretary of Federal Finance. Treasury took note of our  findings, conclusions, and recommendations, and said they were  consistent with their commitment to increasing TIPS issuance in the  context of projected sustained increases in federal debt. Treasury  reiterated that they are committed to issuing TIPS in a regular and  predictable manner across the yield curve, and noted that they are an  important part of their overall debt management strategy. Treasury also  noted that it is always reviewing the appropriate composition of the TIPS  program.
We are sending copies of this report to the Secretary of the Treasury and  other interested parties. We will also make copies available at no charge  on the GAO Web site at http://www.gao.gov. If you or your staff have any  questions about this report, please contact Susan J. Irving at (202) 512- 6806 or irvings@gao.gov. Contact points for our Offices of Congressional  Relations and Public Affairs may be found on the last page of this report.  GAO staff who made major contributions to this report are listed in  appendix III.
section_title: Appendix I: Treasury Inflation Protected Securities
subsections: section_title: Overview
paragraphs: Treasury Inflation Protected Securities (TIPS) are marketable securities  for which the principal is adjusted by changes in the Consumer Price  Index for All Urban Consumers (CPI-U).  With inflation (a rise in the  index), the principal increases. With deflation (a drop in the index), the  principal decreases for the purpose of calculating interest payments, but  the principal to be repaid at maturity is at least par value (or the principal  amount at date of original issuance). Although the inflation-adjusted  principal is paid by the Department of the Treasury when the security  matures, interest payments are made every 6 months. TIPS are the only  Treasury security that secures the investor a return on the investment that  is guaranteed in purchasing power terms rather than in dollar terms.
section_title: Principal
paragraphs: At maturity, Treasury pays investors the greater of the inflation-adjusted  principal amount or the par value. That is, investors are protected against  both increases in inflation and the loss of the original principal. During the  lifetime of a TIPS, the principal could decline with deflation below the  original par value, so the coupon payment could fall below their originally  stated dollar amounts, but at maturity the principal will be redeemed at no  less than the original face amount.
section_title: Interest Payments
paragraphs: Interest is paid every 6 months at a fixed rate, which was determined at  auction when the security was first sold. However, because the rate is  applied to the adjusted principal, interest payments may vary from one  period to another. Interest payments are based on the inflation-adjusted  principal on the date of the interest payment.  In a period of inflation, the  principal is adjusted upward so the interest payment increases. In the  event of deflation, the principal is adjusted downward, and the interest  payment decreases.
Below is an illustrative example of how to calculate the inflation  adjustments to the principal and the semi-annual interest payments (note  that CPI-U numbers and rates are purely hypothetical).
How to Calculate an Inflation-Indexed Security Interest and Principal  An inflation-indexed security with par value of $1,000,000 was purchased on April 15,  2003, with a coupon rate of 3.5 percent. The first semi-annual interest payment date for  this inflation indexed security is October 15, 2003. The reference CPI-U number for the  issue date was 120. The reference CPI-U number for the first interest payment was 135.
section_title: Taxation
paragraphs: Both interest payments and the inflation adjustments applied to the  principal of TIPS are subject to federal tax. The accrued increase in  principal caused by the inflation adjustment is taxable in the year in which  it is accrued, which is the standard structure for all other Treasury  securities. However, with TIPS the increase in principal is an unrealized  gain because the principal is not received until the bond matures. This is  not an issue if TIPS are held in a tax-deferred account.
section_title: Auction Schedule
paragraphs: Treasury currently auctions 5-, 10-, and 20-year TIPS. Treasury used to also  issue 30-year TIPS, but discontinued doing so in 2001. Treasury currently  auctions TIPS on a quarterly basis. The 5-year TIPS is issued in April and  reopened in October.  The 10-year TIPS is issued in January and July, with  reopenings in April and October, and the 20-year TIPS is issued in January  and reopened in July.
section_title: Purchasing TIPS
paragraphs: TIPS are sold in increments of $100, with a required minimum purchase of  $100. Treasury issues TIPS in electronic form. At auction, an investor can  place competitive or noncompetitive bids for TIPS. However,  noncompetitive bids are limited in a single auction to $5 million while  competitive bids are limited to 35 percent of the initial offering amount.   Investors can hold TIPS until they mature or sell them in the secondary  market before they mature.
section_title: Appendix II: The Cost of Treasury Inflation Protected Securities Compared to Nominal Securities
paragraphs: For a sufficiently lengthy time horizon the cost of Treasury Inflation  Protected Securities (TIPS) relative to nominal Treasury securities should  be the same when calculated on both an ex-ante (before the fact) and ex- post (after the fact) basis, all else equal.
The following arithmetic illustrates the approximate equivalence between  ex-ante and ex-post evaluations of the cost of TIPS relative to nominal  securities.
Ex-ante calculation of the cost difference between nominals and TIPS  subtracts a survey-based measure of expected inflation from the nominal- TIPS cost difference.
Again, over the long run, if expected inflation = surveyed expected  inflation = actual inflation, ex-ante and ex-post calculations of the cost of  TIPS relative to nominals should be approximately the same. However, the  possibility of persistent inflation surprises in one direction over a few  years suggests using the ex-ante approach over shorter horizons.
subsections: section_title: Disentangling the Drivers of Recent Shifts in the Nominal- TIPS Yield Differential (Breakeven Inflation Rate)
paragraphs: The cost of TIPS compared to nominal securities increased substantially in  fall 2008 when the subprime crisis intensified.  During the latter part of  2008, TIPS yields rose while nominal yields declined resulting in near  historic lows in the breakeven inflation rate, approaching zero by the end  of 2008. During 2009, breakeven rates generally rose from their late-2008  lows and reached the 2 percent range in early August.
Disentangling the Drivers of Recent Shifts in the Nominal-TIPS Yield Differential  (Breakeven Inflation Rate)
The sharp decline in breakeven inflation rates in late 2008 can be attributed to a  combination of liquidity and technical market factors. Strong flight-to-liquidity flows during  the market upheaval boosted the demand for nominal Treasury securities.  Because TIPS  markets are less liquid than nominal Treasury markets, this reduced the breakeven  inflation rate.
In addition, technical market factors closely linked to liquidity effects appear to have  contributed to the decline in breakeven inflation rates. Lehman Brothers owned TIPS as  part of repo trades or posted TIPS as counterparty collateral. Because of Lehman’s  bankruptcy, the court and its counterparty needed to sell these TIPS, which created a  flood of TIPS on the market. There appeared to be few buyers and distressed market  makers were unwilling to take positions in these TIPS. As a result, the TIPS yields rose  sharply.
Inflation expectations and the inflation risk premium, two other important determinants of  the nominal-TIPS yield differential, appear to have had negligible roles in the recent shifts  in the yield differential. The median survey value of 10-year inflation forecasts compiled by  the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters displayed  little variation over the last 2 years, which implies that long-term inflation expectations  remained stable. Estimates also suggest that the inflation risk premium has remained  relatively small and fairly stable.
Some financial economists view the experience with TIPS yields after the Lehman  bankruptcy as a highly abnormal market situation where liquidity issues suddenly created  severe financial anomalies. They suggest that this was an unrepresentative episode and  that observations from this period could be ignored.
See John Campbell, Robert Shiller, and Luis Viceira, “Understanding Inflation-Indexed Bond  Markets,” Working Paper Presented Brookings Institute (March 2009); and Ingo Fender, Corrinne Ho,  and Peter Hordähl, “Overview: investors ponder depth and duration of global downturn,” BIS  Quarterly Review (March 2009).
section_title: Appendix III: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Jose Oyola (Assistant Director),  Tara Carter (Analyst-in-Charge), Mark Kehoe, Erik Kjeldgaard, Richard  Krashevski, Margaret McKenna and Jason Vassilicos made contributions  to the report. Julie Matta, Rick Cambosos, Stuart Kaufman, and Greg  Wilmoth also provided key assistance.