Treasuries With A Twist

Inflation has remained at 3% for the past three years, but bond traders are convinced that won't last. Fearing that a price surge lurks around the corner, the credit market is demanding a hefty five-percentage-point premium on long-term government bonds. That has sent Treasury yields above 8% and become a source of mounting frustration for the Clinton Administration. Confident that inflation is well in check, it frets that high bond yields will slow economic growth and drive up the government's cost of borrowing even further.

What to do? The Clintonites are now studying a debt instrument used by Brit-

ain: inflation-indexed bonds. By 1996, Treasury may begin issuing some long-term debt with a guaranteed real rate mf return. The yield on the debt would be linked to a common inflation measure, such as the consumer price index, and would probably bring investors a real return of 2% to 4%.

STREET SKEPTICS. Administration propmnents of the plan believe that by providing investors with ironclad assurance that inflation won't erode the purchasing power of their bonds, bills, or notes, Treasury could finance part of the federal debt at a lower rate than it could obtain on conventional debt, especially if inflation remains tepid.

The Reagan Administration briefly considered issuing indexed debt during the early 1980s. But it dropped the plan in the face of stiff opposition from Wall Street, which still doesn't like the idea. Dealers fret that if inflation risk is eliminated, bond holders will then lessen the pressure on the government to hold prices and the national debt in check. They also worry that indexed bonds could significantly reduce the trading volumes and sales of profitable hedging instruments.

Treasury officials believe that the opposition from the dealers will be offset by the desire of pension-fund managers to protect their vast portfolios from inflation. Mutual-fund operators including Fidelity Investments and Benham Group have indicated interest in marketing indexed-bond funds to an aging population, whose paramount concern is guarding long-term savings from the ravages of inflation. Because of the recent growth of mutual and pension funds, "the market has changed rather dramatically since the mid-'80s," says Deputy Assistant Treasury Secretary Darcy Bradbury.

Indexation also enjoys support from Federal Reserve Chairman Alan Greenspan and Vice-Chairman Alan S. Blinder, who has taken to peppering Wall Street executives and money managers with questions on the plan. Fed officials, who Blinder says "have been spending a lot of time since February wondering what was behind the runup in bond yields," think indexed debt might give them a clearer view of real rates and inflation expectations than they currently can obtain.

Before indexed bonds can hit the street, Treasury will have to resolve technical questions about auction methods, tax treatment, and what inflation measure to use. As a result, Bradbury says, no sales are likely before 1996. At that, Treasury would begin with a small issue--perhaps $1 billion. But indexation "has a better chance than at any time in the past," says Blinder, a former Clinton economic adviser. If so, the Clinton Administration could change the face of how the government raises money. And, for that matter, how investors hedge against inflation.

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