The first issuance of inflation-indexed Treasury bonds in January will prompt new portfolio strategies for pension funds and endowments, and possibly a new asset class rivaling traditional inflation hedges like real estate.
"I anticipate this will be one of the most dynamic developments in the institutional market over the next five years," said John Brynjolfsson, vice president and fixed-income portfolio manager, Pacific Investment Management Co., Newport Beach, Calif.
Institutional interest isn't necessary predicated on the investor's outlook on inflation.
"For us, our interest has a similar reason as for fixed income, as a risk reducer and diversifier," said Ronald A. Walter, vice president and director-investments for Citicorp's own $3 billion domestic employee pension fund.
At Stanford Management Co., which oversees the $3.6 billion endowment fund of Stanford University, Menlo Park, Calif., Anne Casscells, managing director-investment policy research, said: "You don't have to have inflation to rise to have (the new bonds) do well, if they are providing a competitive real yield to nominal bonds."
Bridgewater Associates Inc., Wilton, Conn., already manages a $225 million portfolio consisting of foreign-issued inflation-indexed bonds for U.S. pension funds. Dan Bernstein, director-research, said the firm has seen "significant interest" from pension funds, endowments and foundations. He thinks most funds will have an asset allocation to inflation bonds.
Bridgewater plans to include the U.S. inflation bonds in an existing foreign inflation-index bond portfolio to create a global portfolio.
"If inflation picks up - and no one really thinks it will happen - it's nice to think you'll be insulated," he said. "But our view is inflation is about as low as it's going to go. You're not going to see it fall to 1%."
A new asset class
Mr. Brynjolfsson considers the new inflation-protection bonds, as the Treasury will call them, definitely a new asset class.
"To lump these (inflation bonds) in with traditional or nominal bonds makes little or no sense, given (traditional bonds) are a hedge against deflation and (inflation bonds) are a hedge against inflation. Clearly they serve different roles."
Brent R. Harris, managing director at PIMCO, said the new bonds "will probably develop into a separate asset class because it has return characteristics different from (traditional) bonds, and adding these to a portfolio makes for more of an efficient frontier. This will probably grow into a viable new asset class over time."
The new bonds "will be a very good substitute for traditional inflation hedges, such as real estate, managed futures, farmland and gold," he added.
The inflation-indexed bonds have one advantage over traditional inflation hedges. "In the event of deflation, these (bonds) won't go below zero (in their return)," he said. "That is not a feature of typical inflation hedges.
"These will be very good substitutes for traditional inflation hedges. Your pension fund would be miles ahead if you could have replaced commercial real estate with these (inflation) bonds in your portfolio in the 1980s," he said. "Inflation bonds are much more liquid than real estate and a lot of the other traditional inflation hedges."
Mr. Harris, who also is chairman of the PIMCO Funds, said the firm is considering creating of a mutual fund that would use real return bonds, or inflation-indexed bonds, as one of its primary investment vehicles. He said PIMCO would market it to 401(k) plans and others.
No benchmarks yet
But don't look for any benchmarks real soon.
Major producers of fixed-income benchmarks have either excluded the soon-to-be-issued Treasury securities from their widely used performance bogeys or have yet to decide on inclusion.
At Salomon Brothers Inc., New York, Carol Sabia, vice president-fixed income index group, said the bonds are a new asset class so the firm won't be including them in bond indexes. "We're thinking of creating a separate index to track their performance over time," she added.
At Lehman Brothers, New York, an official said no decision has been made on whether to include the bonds in its indexes or to create a separate one.
J.P. Morgan Securities Inc., New York, will exclude the inflation-protected bonds from the J.P. Morgan Government Bond Index, according to William J. Falk, vice president. Morgan will review its decision in mid-1997 after the bonds have traded in the market for six months.
But benchmarks or not, the bonds should be welcomed by all investors, Mr. Brynjolfsson said. "Essentially these bonds are an insurance policy against government irresponsibility," an "incentive for the government to keep inflation under wraps."
"We believe these bonds are a very bullish development for the nominal bond market," Mr. Brynjolfsson said.
Citicorp's Mr. Walter said the Citicorp pension fund is considering investing in the new bonds "assuming the prices are attractive."
The fund would invest in the bonds through Bridgewater. It has invested in the Bridgewater inflation-index portfolio since last year, assigning $55 million.
Mr. Walter, who was consulted by Treasury Department officials doing market research on the new bonds, said the bonds "have the same return as traditional bonds over the long term, but a lower correlation, because equity returns don't come out of inflation."
Performance of the foreign inflation-index portfolio, which has issues from the United Kingdom, Australia and Canada, has been OK, he said.
"Inflation-index bonds are there as a hedge for inflation," he added. "I would rather they not do so well, because then inflation is low and that's better for our fund. They will have extraordinary returns only if inflation is extraordinary, and I'd rather that not happen."
Ms. Casscells said the Stanford endowment was looking at the bonds "with a great deal of interest." She said the endowment "views them as a special inflation-hedging asset class."
Stanford has invested in the Bridgewater overseas portfolio since earlier this year; she declined to disclose the amount. She said the endowment would invest in the U.S. product through Bridgewater, if they are attractive.
Like Mr. Walter, she suggests the initial issue could have a real yield of 31/2%. "That's pretty good," she said, "comparable to the real yield on nominal bonds."
Advantages over regular bonds
Ms. Casscells said she believes inflation-indexed bonds will have several advantages over regular bonds. They will have lower risk because they aren't exposed to inflation and will have a lower correlation to stocks and other assets, enhancing diversification value.
"At the same real yield, inflation-index bonds will be more attractive than traditional bonds," she added. But "in a deflationary environment, they will be at a disadvantage."
"The demand for inflation-indexed bonds could push yield down and make them unattractive to Stanford,"Ms. Casscells said.
The Treasury Department will sell the new bonds in 10-year maturities in a Jan. 15 auction but hasn't disclosed how much it will issue. Mr. Bernstein said it could be several billion dollars.
Mr. Brynjolfsson suggested issuance in the $2 billion to $5 billion range. "Within five years (with subsequent auctions) that could create a $40 billion market. I think that's a lot."
Mr. Bernstein noted the U.K. inflation-indexed bonds, first issued in 1981, now make up 15% of the country's sovereign debt, the equivalent of $60 billion.
In Canada and Australia, which have issued them, respectively, since 1991 and the mid-1980s, the inflation-index issues make up about 4% of each of their government debt issues, or the equivalent of about $5 billion each.
"The way these bonds are looked at in the (United Kingdom) is as a definite substitute for equity," PIMCO's Mr. Brynjolfsson said. "It seems these bonds would do better against inflation than equity, which sometimes is regarded as an inflation hedge. But in the 1970s, equities did poorly against (rising) inflation and so did bonds."
Speaking of the impending U.S. issue, he said, "The ironic thing about these bonds is that even though they are called inflation-protection bonds, you don't need to know what inflation rate of the future will be to know the value. To value them you need to know what real interest rates will be."
The reason: "Because the bonds insulate you against errors in an inflation forecast. You need to have an inflation forecast to appropriately value nominal bonds."
Strategic application important
Aside from any special mutual fund Mr. Harris mentioned, Mr. Brynjolfsson said, "As a tactical investor, PIMCO would be interested in buying these when it's clear they offer competitive returns to traditional fixed-income investments.
"But we feel the more important evolution is the strategic application of these bonds, such as investors trying to take advantage of the special characteristics of these bonds for inflation protection," Mr. Brynjolfsson said.
"An interesting development as a result of them is that institutional investors will be coming to grips with their strategic goals and .*.*. if they revolved around achieving real returns or nominal returns. If they revolve around achieving real returns, I expect a substantial flow out of equities and cash to inflation bonds."
"For an endowment trying to achieve a real return objective, then a strategic allocation to inflation-protection bonds has to be explored. Inflation-protection bonds provide a risk-free anchor to a funds's asset allocation."
Mr. Brynjolfsson said the bonds would not be a good choice for immunized or dedicated portfolios. "Because nominal liabilities are fixed in dollar terms, they have no relation with what inflation is. You want to match nominal liabilities with nominal assets, such as traditional bonds."
"Pension funds typically are a mixture of nominal components and real (or inflation-sensitive) components," Mr. Brynjolfsson added. "If a pension liability is tied to any year's wage increase, then inflation bonds might help," he said.