Lecture outline Bonds with real return Main investors in indexed bonds Saving bonds

Bonds with real return In 1971 article in Newsweek Milton Friedman proposed that that government pays compensation for any losses due to inflation to bondholders. He suggested that interest rates on bonds should not be fixed, but include this compensation for price level rises. On the other hand, Treasury tries to avoid changes in interest payments and achieves through changing the structure of public debt. It swaps short term securities for long term ones so that investors may believe now there are better securities on the market and not demand review of interest rates

Bonds with real return Bonds with real return or real return bonds, like nominal bonds, have reinvestment risk. But unlike nominal bonds, they are independent from other types of bonds with certain risks and cannot be swapped. At present financial institutions do not offer inflationary risk free assets. At the same time, price level changes, at times chaotically, and no government can guarantee their stability. So financial institutions make investor bear any risks associated with price level changes. In the absence of bonds with real return, investor have to accept risks from company shares and thus seek compensation for inflation. But this way of hedging against inflation is nevertheless subject to market risk.

Bonds with real return Pension funds and financial institutions cannot provide compensation for inflation unless they themselves have source of income which pays this compensation. In fact, it is only government which can offer this kind of instrument – indexed bonds. Once financial institutions have real return bonds, they could use them to sell their contracts with inflationary risk. Over time, these contracts would provide less return to investors due to lower risk Opponents argue that real return bonds weaken natural anti- inflationary measures present in economy. These measures include loss of purchasing power and decrease of consumption expenditures. In other words, consumers should bear the cost of inflation.

Bonds with real return On the other hand, Treasury gains from inflation and for this reason it may not welcome real return bonds. It presents the following arguments against real return bonds:  Indexation puts enormous pressure on the government budget.  Implementation of real return bonds will decrease the overall liquidity of the bonds market. The market will becomes fragmented and intra-market trade will decrease. Low liquidity causes investors to demand higher interest rate.

Bonds with real return Example: Nominal bond offered at face value of 1000 dollars with 5 percent annual interest payments. Indexed bond offered at face value of 1000 dollar with 3 percent annual interest payment on indexed principal. Rate of inflation is 2 percent. Although indexed bond offers lower annual payments than nominal bond does, in overall, it brings more payoffs at the time of principal payment.

Nominal bondsIndexed bonds year nominal principal real principal nominal interest real interest nominal principal real principal nominal interest real interest total Total nominal payments: 1500 vs. 1554,06

Main investors in indexed bonds In the absence of inflation indexed bonds, risk averse investors shorten their holdings and accumulate cash alike assets Indexed bonds should be attractive to:  Risk averse persons who do not want to pay high tax rates  Those who do not want to take inflationary risks  Those who are not afraid of fluctuations in real income

Main investors in indexed bonds In the US interest income on nominal and indexed bonds are taxed. Moreover, investors are obliged to report any increase in capital amount due to inflation. Some economists predicted that taxing increased part of principal of bonds imply that the indexed bonds do not fully compensate for inflation and therefore demand for these bonds comes from investors who are free from tax. According to Treasury of the US, inflation indexed bonds will be demanded by those who save for retirement on accounts which are exempt from taxes (Treasury Press Release. Questions and Answers on Marketable Inflation-Protection Securities, May 16, 1996).

Main investors in indexed bonds In Canada the investors in the indexed bonds are offered delayed tax scheme In the Great Britain, the holders of indexed bonds are exempt from taxes Even in the countries where indexed bonds are taxed, the government may increase incentives to buy these bonds by decreasing tax rates for compensation against inflationary risks However, inflation indexed bonds are not the only tool for funds such as pension funds to hedge against inflation. The managers of these funds find investing in company shares more profitable.

Saving bonds Only households have their budgets with surplus. This is how they differ from other sectors of economy For this reason the governments of the US, Canada and Germany invested in easing the access of large masses of the population to buy bonds. Nowadays everyone can buy bonds directly from Treasury through internet. This access is given exclusively to the population, not companies.

Saving bonds In the US, the access of the population to the government bonds was initiated in By now, the Americans can buy the following series of bonds:  EE/E  HH/H  I

EE/E series bonds EE/E series bonds offer income on variable market interest rate for saving deposits. This interest is based on the average of interest payments of 5 year bonds and announced by Treasury in May and November. Bonds with EE/E series are offered at 50 percent of the nominal value. Treasury guarantees that after 17 years, it will buy back these bonds at least at nominal value. One person cannot buy more than 30 thousand dollar worth bonds per annum. The holder of EE/E series bonds can cash them out after six months after the purchase period. But he has to pay fine equal to three month income on this bond.

HH series bonds HH series bonds provide current income to investor. Unlike EE/E series they do not have capital gain. Once purchased by face value (500, 1000, 5000 and doll) investor receives income twice a year on fixed interest rate. HH series bonds cannot be bought for cash. They can be swapped for EE/E series, saving notes or when reinvesting into other HH series at the time of maturity. This swap allows the investor to receive the interest payments twice a year (not once a year as in EE/E series) and delay tax payments until next swaps.

I series bonds I series bonds are inflation indexed bonds which are constructed out of EE series bonds. I series bonds have fixed interest and variable interest. Variable interest is equal to the rate of inflation. Variable interest rate is based on consumer price index. Consumer price index may change when base year changes but Treasury will be using the previous base year. I series bonds are issued for 30 years maximum. The principal amount of the I series bonds increases on the first day of each month. Even if there is deflation, payments will not be decrease below fixed interest rate. This way the government hedges against deflationary risk.

I series bonds Face value of I series bond varies between 50 and dollars. One person can buy not more than dollar worth bonds per annum Income of I series is not subject to local taxes, federal taxes can be delayed for 30 years or until next purchase agreement. Also, income from I series can be exempt from taxes if it is spent on tuition fees in the pre-selected universities.

Saving bonds in Canada Every third family in Canada has saving bonds since they are very popular with citizens. First, there began trading saving bonds in percent liquidity is guaranteed by the government. They can be cashed out at any moment and bank on the face value. Treasury in Canada also issues bonds with premium, which is added to fixed income of the bond. Premium and interest rate can be increased at any time once the market allows this.

Saving bonds in Germany In Germany, federal savings bonds have been issued since 1969 and can be of A and B types. A type pays interest payment once a year while B type pays both interest and principal payments at the end of maturity period after seven years. These bonds offer gradual interest payments, increased at fixed intervals till the maturity in order to motivate the investors to hold bonds during the entire period. If the market interest changes significantly, the current bonds are repurchased by the government and new ones are issued. There is no secondary market for savings deposits. Liquidity is provided by the Treasury which is obliged to buy back bonds on demand.

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