Commentary: These Bonds Could Blow Up In Uncle Sam's Face

It is hard for an Administration to score political points over its debt management, particularly in the midst of a Presidential campaign. But the Clinton Administration couldn't have bought better coverage of its plan to issue inflation-indexed bonds later this year.

"A victory for good government," raved a New York Times editorial. London's market-savvy Financial Times praised the bonds as a "risk-free asset" that "deserve a warm welcome."

Inflation-indexed bonds could ultimately live up to all this hype. The new securities, which offer a fixed rate of return over the inflation rate, stand to be a smash with unsophisticated individual investors--folks who want to save for retirement and their kids' college tuition without worrying that higher prices or a market crash will erode their nest egg. The bonds also score big with Federal Reserve Chairman Alan Greenspan, who hopes they will help him gauge inflation expectations.

SHIFTING THE RISK. For its part, the Treasury Dept. is betting that the new bonds will lower borrowing costs, because investors will accept lower interest in return for protection against higher inflation. While Treasury has been studying the idea since 1994, one Administration official admits that the timing was designed to win points with voters.

Lost in all the euphoria is a recognition that these bonds mark a wholesale transfer of risk from investors to taxpayers if the economy suffers another price surge and the government has to pay higher rates. Today, it's hard to envision inflation soaring anytime soon. But Greenspan won't live forever, and his successor may not share his intolerance for inflation.

If public demand for indexed bonds runs as high as some experts predict, they could turn into another unfunded liability for the government, along with Social Security and federal pensions. "Isn't this another case where Treasury has promised a new benefit that it hasn't indemnified the taxpayer against?" asks James M. Griffin, investment strategist for Aeltus Investment Management Inc. If indexed bond fever spreads, it could also give renewed rise to the "COLA" mentality that pervaded the 1970s after lawmakers decided to provide a cost-of-living adjustment to Social Security beneficiaries. Since 1972, COLAs have tripled the average retiree's benefits.

For taxpayers, the last line of defense against inflation and government profligacy has been Wall Street's "bond vigilantes," who send interest rates soaring at the first sign the Fed is letting inflation rise. By buying indexed bonds, though, investors will care less about inflation because they will have insurance against it. Indeed, depending on how rates are set on the indexed bonds, investors could have reason to hope for inflation, since periods of low inflation will leave them with returns below those on traditional bonds. That's what happened in Britain in much of the 1980s (chart).

REVOLT? Proponents of indexed bonds are arguing that the prospect of higher interest costs if inflation picks up will force policymakers to act prudently. But if so, why have the perennial deficits responsible for a $5 trillion federal debt failed to scare Washington into a balanced-budget agreement?


The next generation of taxpayers may revolt if indexed bonds result in an even greater debt burden. And that could spell trouble for the bondholders. If Uncle Sam is in a fiscal pinch, he may be tempted to arbitrarily recalculate the inflation rate downward. "When government bears the risk of inflation, I don't trust the long-term ability of politicians to make rational decisions," says Derek Sasveld, senior consultant for Ibbotson Associates Inc.

Treasury officials dismiss any major risks to taxpayers or bondholders, saying that inflation-indexed bonds are intended to be just a niche product. And it's hard to quibble with the Administration's debt management: Treasury's 1993 decision to shift to shorter maturities should save taxpayers about $7 billion over five years. But if indexed bonds prove a hit, it may be hard for Treasury to limit sales. If so, these "risk-free" investments may be anything but.

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