As Larry Summers' TIPS Market Turns 21, a Tune-Up May Be Needed

(Bloomberg) -- The $1.3 trillion U.S. market for inflation-linked debt, the brainchild of former Treasury Secretary Larry Summers, has saved taxpayers billions. Now, as the program prepares to turn 21, it may need a tune-up.

As Larry Summers' TIPS Market Turns 21, a Tune-Up May Be Needed

In an assessment released this month, the current stewards of the nation’s finances saw both pros and cons to Treasury Inflation Protected Securities -- known as TIPS -- which debuted in January 1997. On the plus side, the debt has saved about $49 billion relative to sales of regular notes and bonds. Yet Treasury Secretary Steven Mnuchin’s team expressed disappointment that the obligations have failed to attract a more diversified array of investors.

Summers, Robert Rubin’s deputy at the time TIPS were brought in and later head of the department, calls the securities “a clear success.” But some Wall Street strategists predict changes ahead, such as to the auction calendar, sizes or maturities. The Treasury has a history of adapting its issuance lineup, including shrinking TIPS sales. Aligning its offerings with investor needs is more important than ever as the U.S. faces mounting budget deficits. There’s a risk, however, that any decision to curb TIPS issuance comes just as inflation finally starts to take off, leaving bond investors with a diminished toolkit for hedging.

“I thought it was a good idea to diversify the Treasury’s funding base, to provide people with the option of inflation insurance and for establishing a market indicator for measuring inflation expectations,” Summers, now a Harvard University professor, said in a phone interview. “All three of those things have been borne out over time. And $49 billion is a good savings.”

As Larry Summers' TIPS Market Turns 21, a Tune-Up May Be Needed

The Treasury’s analysis of TIPS, released ahead of this month’s quarterly debt offerings, came at a critical time for the nation’s fiscal overseers: The Federal Reserve has begun to let Treasuries roll off its $4.5 trillion balance sheet, and U.S. budget deficits are expected to climb, even without taking into account potential tax cuts. That means the $14.3 trillion government bond market is poised to grow.

Borrowing Needs

In its Nov. 1 refunding documents, Treasury said it anticipated announcing an increase to nominal coupon-bearing securities and floating-rate debt in February to help meet rising funding needs. Yet it gave no signal that it intended to boost TIPS sales.

“It does seem like for the time being Treasury is not that keen on TIPS issuance,” said Stephen Stanley, chief economist at Amherst Pierpont Securities. “The support or enthusiasm in the market for TIPS is much less than it would otherwise be because people don’t believe we are ever going to get any inflation.”

Thirty-year TIPS show that bond traders expect consumer prices will rise at just under a 2 percent annual rate for the next three decades. Meanwhile, the Fed is sticking to projections that inflation will soon rise to that level, although it’s mostly been below it since 2012.

Amid persistent buying of longer maturities, last month’s 30-year TIPS auction still drew robust demand even as price pressures remain muted. The result was welcome news to bond dealers, in part because the securities are seen as relatively thinly traded and thus harder to unload. Investors get their next crack at buying the debt this week, when Treasury auctions 10-year TIPS.

Buyer Base

In a sign that TIPS haven’t attracted significant new buyers to the nation’s debt, investment funds -- including mutual and hedge funds, asset managers and investment advisers -- have bought the lion’s share of both TIPS and nominal Treasuries since 2012, department data show. In both cases, dealers were the second-biggest buyers.

“It’s no secret that liquidity in TIPS is an issue,” said Subadra Rajappa, head of U.S. rates strategy at Societe Generale SA. “Treasury seems to be saying that sponsorship in TIPS is clearly an issue, with not the kind of breadth of participation from counterparties they would have expected, which leaves it open to changes by Treasury as they see fit.”

The program has undergone tweaks before. The five-year tenor, which was added in 1997, was discontinued in 1998 and then reintroduced in 2004. In 2009, Treasury halted 20-year TIPS sales. In February 2016, it cut the size of TIPS auctions.

The department periodically solicits opinions on products or policy to determine what adjustments might be needed to assure that the government finances itself at the lowest possible cost, according to a Treasury spokesperson.

Adjusting Views

The government should always review its offerings as part of plugging the nation’s deficit in the most cost-effective way, said Amar Reganti, a fixed-income strategist at GMO’s asset-allocation group, and former deputy director of the Treasury’s Office of Debt Management.

“They are supposed to look at the programs and try to decide the sizing, the distribution and if the structure is appropriate for achieving their goals,” Reganti said. “Treasury wants to continue to focus on increasing liquidity in TIPS -- so they may make adjustments.”

For Summers, the securities still make sense.

“My views are at the strategic level, that it’s a good idea for the Treasury to be issuing inflation-indexed bonds,” he said. “The precise tactics in terms of just what maturities, just what timing, just what issuance sizes in current context isn’t something that I have a view on. The important strategic choice is the one we made.”

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