Salomon and the Treasury Securities Auction

Subject: Memorandum for Case “The Harvard Management Company and Inflation-Protected Bonds”

    The Harvard Management Company (HMC) is a separately incorporated, non-profit entity, owned by Harvard University. It provides Harvard University internal management to achieve its investment goals. Its investment strategy has produced a real return of 11.3% in the past ten years. From late Febuary 2000, the president and CEO of HMC has been trying to change Harvard Policy Portfolio by adding Treasury Inflation-Protected Securities (TIPS).

Policy Portfolio determines the long-run allocation of endowment to different asset classes, and it also serves as a benchmark of evaluation of investment strategies. Before adding TIPS to portfolio, HMC has 11 wide assets classes in the policy portfolio, designed to achieve growth goal of 4% to 5% annually in endowment. Now TIPS accounts for 7% of the total portfolio.

TIPS’s structure requires the principal and coupon to change with inflation which is determined by Consumer Price Index. Like nominal Treasury notes and bonds, TIPS pay semi-annual coupons at a fixed coupon rate. However, TIPS’ principal is not fixed over the life of the bond. The Inflation-adjusted principal value at time t equals to the product of stated value at issuance times index ratio. And index ratio equals to CPI at time t divided by CPI at issuance.

Taxable income of TIPS are interest payments from TIPS. Like other treasury securities, TIPS are exempt from state and local tax, but its interest payments are taxed at the federal level. With inflation rate bigger than zero, TIPS are taxed more heavily than nominal bonds, because accretion to principal is taxed in the period in which it is made.

 (Q1:Describe how TIPS are structured, in particular, how do coupons and principal vary with inflation/deflation and how are they taxed? Are they taxed more heavily than nominal bonds?)

It is rational for HMC to invest in TIPS. Many treasury notes and bonds usually have fixed principle and coupon payments, so when inflation happens, buyers get loss in purchasing power terms.

But TIPS’s principle and coupon payments grow at the rate of inflation, so it has fixed purchasing power, which is more stable than other instruments in risk. Just like what is shown on the website, the CPI index has been growing steadily since 1994, which means there was inflation in almost every year, so it is wise for Harvard University to invest their endowment fund into TIPS to avoid losses.

 (Q3: What is the rationale for investing Harvard University’s endowment fund in TIPS? Consider evidence in http://research.stlouisfed.org/fred2/series/CUUR0000SAE1?cid=32421 when giving an answer.)

Jack Meyer and his team had been watching TIPS market since 1997. They considered TIPS to be attractive because of its high yield of 3.2% to 4.5% and inflation-protective characteristics. However, they thought 2% real return on cash they assumed historically in their portfolio analysis was too low, and that a better estimate was 3.5%.