Amendments to the Uniform Offering Circular for the Sale and Issue of Marketable Book-Entry Treasury Bills, Notes and Bonds

DEPARTMENT OF THE TREASURY

Office of the Assistant Secretary for Financial Markets

Fiscal Service

31 CFR Part 356

Amendments to the Uniform Offering Circular for the Sale and

Issue of Marketable Book-Entry Treasury Bills, Notes and Bonds

AGENCY: Office of the Assistant Secretary for Financial Markets,

Treasury.

ACTION: Advance Notice of Proposed Rulemaking.

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SUMMARY: The Secretary of the Treasury (Secretary) is authorized under

Chapter 31 of Title 31, United States Code, to issue United States

obligations and to offer them for sale under such terms and conditions

as the Secretary may prescribe. The Department of the Treasury

(Department or Treasury) is issuing this Advance Notice of Proposed

Rulemaking to solicit comments on the design details, terms and

conditions, and other features of a new type of marketable book-entry

security the Treasury intends to issue, inflation-protection notes or

bonds, with a return linked to the inflation rate in prices or wages.

The Treasury is specifically interested in comments concerning choice

of index, structure of the security, auction technique, offering sizes,

and maturities. The Treasury also invites comments on other specific

issues raised, as well as on any other issues relevant to the new type

of security.

DATES: Comments must be received on or before June 19, 1996.

ADDRESSES: Comments should be sent to: the Government Securities

Regulations Staff, Bureau of the Public Debt, 999 E Street NW., Room

515, Washington, DC 20239. Comments received will be available for

public inspection and copying at the Treasury Department Library, Room

5030, Main Treasury Building, 1500 Pennsylvania Avenue NW., Washington,

DC 20220.

FOR FURTHER INFORMATION CONTACT: Norman Carleton, Director, Office of

Federal Finance Policy Analysis, Office of the Assistant Secretary for

Financial Markets, at 202-622-2680. In addition, the Treasury plans to

hold a series of investor meetings in New York, Washington, DC,

Chicago, Boston, San Francisco, and possibly other cities in late May

and in June 1996 to discuss the new securities, answer questions, and

solicit comments. To request information about attending any of these

meetings, contact the Office of Financing, Bureau of the Public Debt,

at 202-219-3350.

SUPPLEMENTARY INFORMATION: The Treasury Department intends to issue a

new type of marketable book-entry security with a nominal return linked

to the inflation rate in prices or wages, as officially published by

the United States Government. The Treasury is considering various

indices for this purpose, including the Consumer Price Index for All

Urban Consumers (CPI-U) published by the Bureau of Labor Statistics

(BLS) of the Department of Labor, the core CPI (CPI-U, excluding food

and energy, as published by the BLS), the Gross Domestic Product (GDP)

deflator published by the Bureau of Economic Analysis (BEA) of the

Department of Commerce, and the Employment Cost Index--Private Industry

(ECI) also published by BLS. Through this notice, the Treasury is

soliciting comments on the design details of the planned inflation-

protection securities and on which index (those mentioned above or

another index) would be most likely to result in the broadest market

for the new securities. At the end of this notice is a hypothetical

term sheet with proposed formulas applicable to one of the structures

being considered for the new security.

This advance notice of proposed rulemaking is not an offering of

securities, and any of the currently contemplated features of

inflation-protection securities that are described in this notice may

change. The terms and conditions of particular securities that may be

offered will be set forth in

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the Uniform Offering Circular (31 CFR Part 356) and the applicable

offering announcement.

The Department intends to issue inflation-protection notes or bonds

in order to save on interest costs and to broaden the types of debt

instruments available to investors in U.S. financial markets. Because

the Treasury, rather than the investor, would bear the inflation risk

on an inflation-protection security, the Department expects that the

prices at which it would sell this new type of security would capture

some or all of the inflation risk premium charged by investors on

conventional Treasury securities. In other words, investors should be

willing to pay extra for a security on which the issuer, rather than

the investor, bears the risk of higher than expected inflation.

Consequently, the expected interest costs to the Treasury of inflation-

protection securities should be lower than those on conventional

Treasury securities.

In addition, inflation-protection securities may prove to be

attractive investments to investors who do not now invest in Treasury

securities to any significant extent. For example, certain pension

funds that currently invest in bonds other than Treasury securities

because of the higher yields on private fixed-income securities may

find Treasury inflation-protection notes or bonds useful to include in

their portfolios. The new securities would offer explicit inflation

protection to investors, which has heretofore been unavailable in a

Treasury debt instrument. This inflation protection could prove

attractive for investments for retirement. Also, because the path of

changes in market prices of inflation-protection securities would be

markedly different from that of the market price of conventional fixed-

income instruments or equity investments, inflation-protection

securities could be useful for achieving some portfolio

diversification. This broadening of the market for Treasury securities

should also result in lower overall interest costs for the Treasury

over time.

Indexation Methodology. A design of the inflation-protection

securities that is currently being considered is modeled, with some

modifications, on the Real Return Bonds currently issued by the

Government of Canada. The Department is soliciting comments about this

choice of model and the specific details described below and in the

hypothetical term sheet, as well as the formulas in the appendix.

For this particular structure, the principal amount of the

inflation-protection security is adjusted for inflation, so that the

adjusted value remains the same in constant dollars. This is achieved

by multiplying the principal value of the security at issuance by an

index ratio. The index ratio is the reference index number applicable

for the valuation day divided by the reference index number applicable

for the issue date.

Because the reporting of a monthly price or wage series index

number for a particular month by necessity takes place after the month

has ended and because the market needs to determine accrued interest on

a daily basis, there has to be a lag in the indexation of the security.

For this structure, if it is based on a monthly index that is reported

in the following month, the indexation of the principal on the first

day of any month is based on the index number for the third preceding

month. For example, the index number applicable to the first day of

December is the one reported for September. For other days of the

month, a linear interpolation is made between the index number for the

third preceding month and the one for the second preceding month (in

this example, October). Using the third preceding month as the

reference month is the minimum lag that enables interpolation between

the index number for that month and the following month.

Under this structure, interest is payable semiannually. Interest

payments are a fixed percentage of the value of the inflation-adjusted

principal, in current dollars, for the date on which it is paid.

Alternative Structures. The Treasury has given the most study to

the Canadian model for inflation-protection securities, which in turn

is a modification of the United Kingdom's index-linked gilts. However,

alternative structures are possible, and the Treasury is asking for

comment on whether alternative structures might be more desirable for

U.S. financial markets.

One alternative structure is a zero-coupon inflation-indexed

security. This type of security could prove to be quite volatile in

price, but, if held to maturity, this structure would provide the

greatest certainty about its return, since there would be no

reinvestment risk associated with coupon payments.

In addition to general comments concerning the market for a zero-

coupon inflation-protection security, the Treasury is soliciting

comments about the use for this structure of an index, such as the GDP

deflator, that is subject to retroactive revisions. Since the Treasury

would only make one payment on a zero-coupon inflation-protection

security, revisions would be less of a problem from the cash flow

perspective than with a security that pays interest every six months.

However, the use of an index that is revised retroactively may cause

some impediments to trading the security and would complicate the

applicable tax rules.

Another quite different structure is an inflation-protection

security that pays out principal and interest at periodic intervals.

Ignoring the lags, under this structure, each payment is equal in real

terms, but the proportion of each payment representing principal and

interest changes. In other words, this structure is similar to the cash

flows of a home mortgage, and, more specifically, a price level

adjusted mortgage. This structure may be appealing to investors

desiring a flow of periodic payments that stay constant in real terms.

It is also possible that this structure may be more appealing than a

Canadian-type security to taxable investors concerned about receiving

sufficient cash payments from the security to satisfy the tax on the

income from the security.

Price or Wage Indices. The Treasury is requesting comments on which

price or wage index is likely to result in the broadest market for

inflation-protection securities. Specifically, the Department is

considering (1) the CPI-U, (2) the core CPI, (3) the GDP deflator, and

(4) the ECI. The Treasury also requests comments on whether another

index would serve the desired purpose better.

The CPI-U is the best known measure of inflation, and, as such, is

a logical candidate for indexing the securities. However, the CPI-U may

not be the best index for certain investors. For example, pension

funds' liabilities are more sensitive to change in wages than to

changes in consumer prices.

The core CPI is a less volatile index than the CPI-U, and this may

be appealing to investors. However, while energy and food prices

eventually influence other prices, the core CPI could be criticized for

not completely reflecting any trend that may develop in prices in the

energy and food sectors.

The GDP deflator is a broad measure of price trends in the economy.

As noted above, its use may be better suited to a zero-coupon

inflation-protection security than to a note or bond paying semiannual

coupons, because the GDP deflator, unlike the other indices under

consideration, is subject to periodic revision.

Periodic revisions of an index pose three potential problems. The

first is the need for finality in determining payment amounts. Second,

the change in an index for a given period could be based on an index

number for a previous period that has since been

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revised. An indexation methodology designed to correct for revisions in

previous values of the index would create additional complexity.

Finally, even for a zero-coupon security, revisions may cause

complications in the applicable tax rules throughout the life of the

security. Revisions may be less of a problem for a security that makes

only one payment at maturity than for one that pays interest every six

months.

The ECI may appeal to pension funds, whose liabilities are more

linked to wage, rather than price, inflation. In this regard,

commenters are also asked to address whether the total compensation or

the wages and salaries series of the ECI would be the most useful.

Since the ECI is a quarterly index, the precise indexation methodology

and the formulas in the appendix, which assume a monthly index, would

need to be modified.

The Treasury is also requesting comments on whether a seasonally

adjusted or non-seasonally adjusted series would be preferable.

Seasonal adjustment smoothes out fluctuations, but seasonal factors are

subject to revisions for a considerable period of time.

Calculation of the Price or Wage Series. From time to time,

government statistical agencies, such as the BLS and the BEA, revise

their methodology for calculating indices in order to improve their

accuracy. Such revisions on a forward-going basis may affect the

inflation rate as measured by the index and, therefore, the return to

investors.

For a Canadian-type or level real payment inflation-protection

security, revisions of a price or wage index number that has previously

been reported, however, would not be used for calculations of principal

value or interest payments. This is in order for there to be finality

in determining payment amounts.

When a price or wage index is rebased to a different year, the

Treasury would use the price or wage index series with the same base

year(s) as when the security was first issued, as long as that series

continues to be published. The reason for this is to maintain precision

in the indexation of the security that may otherwise be lost due to

rounding, a problem that becomes more acute if the price or wage index

has increased significantly from the original base year(s) to the new

one. The Department is specifically soliciting comments on this point.

In the case of an index series reported on a monthly basis in the

following month, the Department is considering the following procedure

for the Canadian-type security if the index is reported late. If the

index number for a particular month is not reported by the last day of

the following month, the Department would announce by the end of the

next business day an index number based on the last twelve-month change

in the index available. This number would be used for all subsequent

calculations and would not be replaced by the actual price or wage

index number when it is reported. Since the Treasury may use a price or

wage series that is not seasonally adjusted, the Treasury welcomes

comments on this procedure. The Department believes that this

calculation would rarely, if ever, be necessary.

If the price or wage index for an inflation-protection security is

discontinued while that security is outstanding, the Treasury would

consult with the agency responsible for the index, and, based on such

discussions, the Treasury would select an appropriate substitute index

and methodology for linking the two series. Determinations of the

Secretary in this regard would be final.

Finally, if the Federal Government commences publication of a new

version of the index that is more appropriate for indexation than the

one originally chosen, the Treasury expects it would then use the new

version for indexing new inflation-protection securities. Concerning

the introduction of a new version, the Treasury is requesting

commenters to address whether the Treasury should also index

outstanding inflation-protection securities to the new version starting

from its introduction or whether outstanding securities should remain

indexed to the original series as long as that series continues to be

published.

Auction Technique. The Department is considering offering

inflation-protection securities through a single-price auction. The

exact type of auction has yet to be determined, and the Department is

particularly interested in input from potential auction participants,

as well as others, on this subject.

For a Canadian-type inflation-protection security, options include

two types of single-price auctions where the Treasury asks for bids in

terms of real yield to three decimal places. In the first case, the

highest accepted yield would become the coupon, and the inflation-

protection note or bond would be issued at par. In the second case, the

Treasury would set a coupon after the auction in an increment of

0.125%, and the price of the security would be determined by the

formulas in the appendix.

Also, the Treasury could announce a coupon on the security and

accept bids in terms of price. However, this option runs counter to the

Department's auction practice for its conventional Treasury securities,

and, at least initially, it may be difficult to judge what would be the

appropriate coupon.

Noncompetitive bids up to $5 million per bidder would be permitted

for inflation-protection securities. In order to ensure that enough

competitive bids are accepted to price the security fairly, the

Treasury is considering whether all or part of the noncompetitive bids

should be filled by issuing more securities than the originally

announced public offering amount. The Department is requesting comments

on this issue.

Given the pricing uncertainty inherent in any new type of security,

the Treasury is requesting comments on whether the Treasury should

announce prior to a single-price auction of an inflation-protection

security that it retains, and may exercise, the option to award an

amount greater or less than the announced public offering amount. The

reason for awarding less stems from the use of the single-price auction

technique and the unique nature of this new instrument. If there were

an extremely long tail between the yield necessary to sell, for

example, 95 percent of the announced size and the remaining 5 percent,

awarding less would avoid issuing the security with an unreasonably

high real yield. (In any case, the Secretary reserves the right, in any

auction, to award an amount of securities greater or less than the

offering amount. See 31 CFR 356.33)

The Department also welcomes comments on whether a single-price or

a multiple-price auction would be more appropriate for inflation-

protection securities.

The Treasury is also requesting commenters to address whether any

of the auction rules for conventional Treasury securities are

inappropriate for an offering of inflation-protection securities and

specifically whether there should be a limit to the amount recognized

at a single yield from a bidder or the amount awarded to a single

bidder in an auction of inflation-protection securities.

Frequency. The Treasury contemplates issuance of inflation-

protection securities on a regular quarterly cycle.

Reopenings. The Treasury could reopen an issue of an inflation-

protection note or bond, though the flexibility to do this under

changing market conditions is conditioned by tax issues involving the

original issue discount rules that have yet to be

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decided. A reopening would also be accomplished by an auction. The

Department welcomes comments on whether bids on an issue that is being

reopened should be in terms of real yield or price.

For a Canadian-type security, amounts bid at an auction for a

reopened inflation-protection security would be in terms of original

par amount, not the inflation-adjusted par amount. The Treasury would

announce prior to the auction the index ratio necessary to convert the

original par amount to the inflation-adjusted par value for the

settlement date. This means that if the index ratio for the settlement

date is 1.03, a $1,000 bid amount would translate into $1,030

inflation-adjusted par value. The Treasury is requesting comments on

this procedure.

Also, the Treasury is requesting comments on whether reopenings of

an issue would be important for market liquidity, or whether they would

act as a constraint on prices, given the possibility of additional

supply of the security in the next quarter.

Maturities. The Department's current thinking is that 10-year

inflation-protection notes or 30-year inflation-protection bonds would

be the most appropriate maturity sectors for this instrument. The

Treasury is soliciting comments on which maturity sectors would be most

in demand for inflation-protection notes or bonds.

Amounts. The Department is requesting comments on the appropriate

size of the initial auctions of inflation-protection notes or bonds.

The Treasury intends to increase the size of the auctions from the

initial levels over time.

Book-Entry Form and Systems. The inflation-protection securities

would be offered only in book-entry form. They would be issued and

maintained in the commercial book-entry system which is operated by the

Federal Reserve Banks, acting as fiscal agents for the Treasury

Department. The Treasury also would make inflation-protection

securities available through TREASURY DIRECT, a system designed

primarily to enable investors who do not intend to trade Treasury

securities to hold their book-entry securities directly on the records

of the Treasury.

Eligible amounts for holding and transferring would be in multiples

of $1000 of original par value for a Canadian-type inflation-protection

security. The Treasury is soliciting comments on any operational issues

arising from the fact that the amount of an inflation-protection

security held and transferred on the book-entry systems would be

referred to in terms of the original par value, not the inflation-

adjusted value.

Treasury Tax and Loan Accounts. The Treasury intends to make

inflation-protection securities eligible as collateral for Treasury Tax

and Loan Accounts. Valuation for collateral purposes would depend on

the precise structure of the security.

Stripping. For a Canadian-type security, the Treasury would make

inflation-protection securities eligible for stripping on the

commercial book-entry system at some point after issuance of the new

security had begun. This would not be operationally possible initially.

Eligibility for stripping might extend only to inflation-protection

securities issued after a future effective date.

Taxation. In general, a payment on an inflation-protection security

or an increase in the principal amount of the security attributable to

the inflation adjustment would be includible in taxable income for the

year in which it occurs and would be treated as interest income.

Interest payments on inflation-protection securities generally would

have to be included in the owner's taxable income when received or as

accrued, depending on the owner's method of accounting for tax

purposes. For a zero-coupon inflation-protection security, the

difference between the issue price and the original par amount would be

interest that the holder would include as taxable income on a constant

yield basis. The precise tax treatment in the event the principal

decreases because of a decline in the price or wage index has yet to be

determined. Other tax issues, including the reporting of income on the

securities by brokers and other intermediaries (i.e., custodians), also

remain to be determined. Relevant tax issues would be announced before

the first issue.

Minimum Guarantee. If the sum of all the interest payments and the

inflation-adjusted principal value at maturity of the inflation-

protection note or bond is less than the par value of the note or bond

at issuance, the Treasury would make an additional payment at maturity

for the difference.

After receipt and consideration of responses to this advance notice

of proposed rulemaking, the Department intends to issue a final rule

amending 31 CFR Part 356, ``Sale and Issue of Marketable Book-Entry

Treasury Bills, Notes, and Bonds'' (Uniform Offering Circular). Because

the rule would relate to public contracts and procedures for United

States securities, the notice, public comment, and delayed effective

date provisions of the Administrative Procedure Act are inapplicable,

pursuant to 5 U.S.C. 553(a)(2).

Hypothetical Term Sheet

Note: This hypothetical term sheet assumes that an inflation-

protection note or bond would be linked to a price or wage index

reported monthly and that the index number for each month is

reported the following month.

Issuer: United States Treasury.

Issue: Inflation-protection note or bond.

Payment Dates: Inflation-adjusted principal on the security will be

paid on the maturity date as specified in the offering announcement.

Interest on the security is payable on a semiannual basis on the

interest payment dates specified in the offering announcement through

the date the principal becomes payable. In the event any principal or

interest payment date is a Saturday, Sunday or other day on which the

Federal Reserve Banks are not open for business, the amount is payable

(without additional interest) on the next business day.

Maturities: Ten or thirty years.

Indexing Methodology: To calculate the value of the principal for a

particular valuation date, the value of the principal at issuance is

multiplied by the index ratio applicable to that valuation date.

Semiannual coupon interest is determined by multiplying the value of

the principal at issuance by the index ratio for the coupon payment

date by one-half the stated rate of interest.

Index Ratio: The index ratio for any date is the ratio of the

reference index number (reference INUM) applicable to such date to the

reference INUM applicable to the original issue date.

Reference Inum: The reference INUM for the first day of any

calendar month is the INUM for the third preceding calendar month. (For

example, the reference INUM for December 1 is the INUM reported for

September of the same year, which is released in October.) The

reference INUM for any other day of the month is calculated by a linear

interpolation between the reference INUM applicable to the first day of

the month and the reference INUM applicable to the first day of the

following month.

Any revisions that the agency responsible for the index makes to

any INUM that has been previously released shall not be used in

calculations of the value of Treasury inflation-protection securities.

In the case that the INUM for a particular month is not reported by

the last day of the following month, the Treasury will announce an

index

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number based on the last year-over-year inflation rate as measured by

the chosen index. Any calculations of the Treasury's payment

obligations on the inflation-protection security that need that month's

INUM number will be based on the index number that the Treasury has

announced.

If the applicable price or wage series is discontinued during the

period the inflation-protection security is outstanding, the Treasury

will, in consultation with the agency responsible for the series,

determine an appropriate substitute index and methodology for linking

the discontinued series with the new price or wage index series.

Determinations of the Secretary in this regard will be final.

Strips: Eligible for the STRIPS program at a future date.

Taxation: Appreciation of the principal will be taxed as interest

income in the period the appreciation occurs. Interest payments will be

includible as interest income when received or as they accrue,

depending on the taxpayer's method of accounting. Other tax details

remain to be determined.

Auction Technique: Single-price auction. Options:

(1) Bidders bid for coupon, with bids expressed to three decimal

places. The highest accepted yield becomes the coupon. Security is

issued at par.

(2) Bidders bid real yield, with bids expressed to three decimal

places. Coupon is set near the highest accepted real yield in

increments of \1/8\ of 1 percent. Price is determined by formula in the

appendix using the highest accepted yield.

(3) Before the auction Treasury announces a coupon, securities are

issued at lowest accepted price.

Minimum Guarantee: If the sum of all the interest payments and the

inflation-adjusted principal is less than the par value of the security

at time of issuance, the Treasury will pay an additional sum at

maturity equal to the difference.

Minimums and Multiples to Bid, Hold, and Transfer: The minimum to

bid, hold, and transfer is $1000 original principal value. Larger

amounts must be in multiples of $1000.

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PART 356--SALE AND ISSUE OF MARKETABLE BOOK-ENTRY TREASURY BILLS,

NOTES, AND BONDS (DEPARTMENT OF THE TREASURY CIRCULAR, PUBLIC DEBT

SERIES NO. 1-93)

Authority: 5 U.S.C. 301; 31 U.S.C. 3102, et seq.; 12 U.S.C. 391.

Date: May 15, 1996.

Darcy Bradbury,

Assistant Secretary (Financial Markets).

[FR Doc. 96-12630 Filed 5-16-96; 11:00 am]

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