Sept. 2 (Bloomberg) -- Almost 12 years after then-Treasury SecretaryRobert Rubin championed inflation-linked bonds as a way to lower U.S. borrowing expenses, advisers toHenry Paulson say they have cost taxpayers an extra $30 billion.
The Treasury Borrowing Advisory Committee, consisting of officials from 14 investment firms including Goldman Sachs Group Inc. and Soros Fund Management, recommends eliminating five-year Treasury Inflation-Protected Securities. At a minimum, the supply of TIPS, now $517 billion outstanding, should be reduced relative to the amount of nominal Treasuries, the committee says.
Treasury Secretary Paulson would be shortsighted to follow that advice, according to Mihir Worah, who oversees the $15.6 billion Real Return Fund for Newport Beach, California-based Pacific Investment Management Co. Depriving investors of one of three maturities in the TIPS market is a step toward raising borrowing costs, not lowering them, he said.
``You can't do this,'' Worah said in a telephone interview. The market ``needs all those liquidity points -- five, 10, and 20 years. I would strongly argue against eliminating the five- year TIPS.''
Defenders say TIPS will save the government money as they become easier to trade. Since Rubin, 70, created the market, only 10-year notes have been auctioned continuously. The government started selling 5- and 20-year maturities at semi- annual auctions in 2004.
Lower Yields
TIPS pay interest on a principal amount that rises and falls with theconsumer price index, which increased 5.6 percent in the year ended July 31. Yields are lower than those of Treasuries because investors expect the inflation payment to make up the difference. The gap between yields on the bonds represents the rate of inflation investors expect during the life of the securities.
The yield on the five-year inflation-linked note due in April 2013 ended last week at 1.23 percent, compared with 3.09 percent for the benchmark 3.125 percent note due in August 2013. The yield climbed to 1.30 percent today.
If inflation ends up higher than expectations, the government pays more on TIPS than on bonds. That's the main reason TIPS cost an extra $30 billion since 1997, according to the Treasury Borrowing Advisory Committee, or TBAC.
Paulson, 62, wasn't available for comment, said Treasury spokeswoman Brookly McLaughlin, declining to say whether he has spoken to Rubin about TIPS. Rubin, who, like Paulson was a chairman of Goldman, didn't return messages left with his office seeking comment.
`Big, Big Program'
Paulson and Rubin worked together at Goldman from 1974 to 1992. In 1988, Paulson was promoted to co-head of investment banking when Rubin was vice chairman and co-chief operating officer. Rubin left the firm in January 1993 to become assistant to President Bill Clinton for economic policy. He became Treasury Secretary in 1995.
The U.S. started selling TIPS in 1997, saying the market would help Americans' retirement savings keep pace with inflation.
Rubin, now a senior counselor to Citigroup Inc. in New York, told reporters in his office in January of 1997 before the first auction that TIPS had the ``potential'' to cut borrowing costs and predicted they would be ``a big, big program someday.'' The bonds account for 11 percent of the Treasury market, up from 6.2 percent at the end of 2004.
TIPS ``have certainly not been an attractive form of financing for the U.S. Treasury,'' the TBAC said in a July 29 report published on the Treasury's Web site. Paulson ``should consider eliminating'' five-year TIPS and focus on longer maturities that better meet needs of pension funds and insurance companies, it said.
JPMorgan to Goldman
The TBAC was formed shortly after World War II and made official through a 1972 act of Congress. It offers quarterly recommendations to the Treasury Secretary on managing the government's debt. Members are appointed by the group's chairman, currently Keith Anderson, the chief investment officer of Soros Fund Management, the New York-based hedge fund founded by billionaire George Soros. Anderson declined to comment.
The group includes Matthew Zames, who oversees trading in government bonds, currencies and municipal debt at New York- based JPMorgan Chase & Co., the third largest U.S. bank; Paul McCulley, a managing director at Pimco, which manages the world's biggest bond fund; and Ashok Varadhan, the head of U.S. interest rate products at Goldman in New York.
During the past 10 years, the TBAC has recommended some of the biggest changes in government financing.
A day after its April 29 report advised resuming sales of 52-week bills for the first time in seven years, the Treasury said it would begin auctions in June.
Record Borrowing
The Treasury stopped selling 30-year bonds nine months after the committee recommended in 2001 that the U.S. eliminate the securities -- just before the government went from budget surpluses to deficits. Sales of the so-called long bond resumed in 2006.
The group is now providing guidance to a government borrowing more than ever. The Bush administration forecast the budget deficit will widen to a record $482 billion in the fiscal year that begins in October. Outstanding marketable U.S. debt reached $4.8 trillion in July, up from $2.98 trillion when the U.S. last recorded a surplus in 2001.
``I'd be very quick to dismiss the recommendations,'' said John Brynjolfsson, chief investment officer of Armored Wolf LLC, a hedge fund in Aliso Viejo, California. ``The five-year TIPS is probably the lowest-risk, best inflation hedge that retirees, foundations, endowments, and other savers can purchase. So it would eliminate their access to the market.''
Brynjolfsson, who formerly managed $80 billion at Pimco, estimates that TIPS have saved the U.S. $275 billion since 1997 by lowering yields on regular Treasuries by 0.25 percentage point to 0.5 percentage point.
Real-Time Referendum
That's because TIPS serve as a real-time referendum on the ability of the central bank and government to contain inflation. Investors who have confidence in the resolve of policy makers to keep consumer prices in check are more willing to lend them money at lower rates, Brynjolfsson said.
Consumer prices rose at an average annual pace of 2.7 percent since 1997, compared with 3.7 percent in the decade before TIPS were sold. The yield on the five-year Treasury averaged 4.53 percent since the market started, versus 7.11 percent in the previous 10 years.
TIPS issued since 2004 may save the government as much as $4 billion because liquidity has improved, according to a 2007 paper by Washington-based Fed economist Jennifer Roush. Liquidity refers the ease with which an investor can trade securities. In general, the less liquid a security, the lower the price and the higher the coupon payments investors demand to own it.
Increased Trading
``Any efforts to foster greater liquidity would be helpful,'' said Wan-Chong Kung, who helps oversee $76 billion in fixed income as a bond fund manager at Minneapolis-based FAF Advisors, the asset-management arm of U.S. Bancorp. ``Paulson perhaps contemplating cutting out five-year issuance would very much run counter to that.''
The primary dealers of U.S. government securities traded an average of $8.2 billion in TIPS each week the last four years, compared with $3 billion in the preceding four. The government sold $63 billion in TIPS in 2004, more than double the amount in 1997. It issued $57 billion last year.
Benefits to Taxpayers
The TBAC is wrong to highlight past costs of a relatively young market without acknowledging TIPS' benefits to taxpayers, said Kenneth Volpert, who manages $17.5 billion of the debt for Vanguard Group in Valley Forge, Pennsylvania. TIPS allow the Fed to make better decisions on setting interest rates to keep consumer price gains in check, he said.
Fed officials referred to TIPS in 12 of 13 policy-setting meetings since 2007, according to minutes of the gatherings. Policy makers led by Ben S. Bernanke mentioned five-year TIPS as recently as their April 30 meeting, where they lowered the benchmark lending rate a quarter-percentage point to 2 percent.
``The bigger TIPS are as a share of the Treasury funding, the more aligned they are with taxpayers' interests,'' Volpert said.
To contact the reporter on this story: Sandra Hernandez in New York atshernandez4@bloomberg.net
