Bailout

What about perpetual TIPS?

By Felix Salmon

Eddy Elfenbein thinks the time is right for the U.S. government to issue perpetual bonds:

I say let?s float some Treasury perpetuities… say that these perpetuities aren?t callable for the next, say, 50 years. We could even call them ?Obama Bonds.? I wouldn?t be surprised if we could lock-in 4%.

I wouldn’t be surprised either. Perpetual bonds are extremely convex, and investors like that. And of course there’s no reinvestment risk.

But the really valuable new instrument, I think, would be perpetual TIPS. Each one would pay a coupon of, say, $10 a month, indexed to inflation. If that 4% yield on nominal perpetual bonds is split into 2% time value of money and 2% expected inflation, then you’d expect one of these bonds, paying $120 per year in 2010 dollars forever, to cost about $6,000.

In other words, if you wanted to lock in an annual income of $60,000 which was guaranteed to rise with inflation, you’d need to pay $3 million up front. At any point, of course, you could sell your bonds to someone else: they’d fluctuate in value, to be sure, but chances are that they wouldn’t fluctuate that much. Long-duration bonds rise and fall a lot in value according to prevailing interest rates, but the main reason why long-term interest rates change is changes in long-term inflation expectations. Once those are stripped out, as they would be in perpetual TIPS, what’s left is relatively stable, in terms of its market value. To a first approximation, the value of the bond would rise in line with inflation.

Better yet, to a second approximation, the bonds would be countercyclical. They would become less attractive, and cheaper, when stocks are booming and interest rates are relatively high — just when the rest of your portfolio is likely to be doing very well. And their value would rise in times of bearishness, when most other markets were falling.

The bonds would be a great way of providing a reliable lifetime income — although of course since they would rise with inflation rather than with wages, the quality of life they buy would probably fall slowly over time. They could also provide a very handy benchmark against which to judge annuity products. On the other hand, they could worry a lot of people saving for retirement. I need $3 million to buy myself an income of $5,000 a month? That’s a scary prospect, to be sure.

Full post as published by Macroprudential on August 27, 2010 (boomark / email).