FIXED INCOME RESEARCH.

Jeffrey D. Biby
jbiby@lehman.com
212-526-6566

Amitabh Arora
aarora@lehman.com
212-526-6566

Governments/Swaps
Ben Martens
bmartens@lehman.com
212-526-6566

Agencies /TIPS

Priya Misra
prmisra@lehman.com
212-526-6566

Anshul Pradhan
apradhan@lehman.com
212-526-6566

Volatility
Vaidyanathan Venkateswaran
vvenkate@lehman.com
212-526-6566

Mortgages
Srinivas Modukuri
modukuri@lehman.com
212-526-8311

Economics
Ethan Harris
eharris@lehman.com
212-526-5477

Wednesday, October 20, 2004
Interest Rate Strategies
Treasuries, Agencies, Swaps, Futures & Options
5 year TIPS Roll Talk

SUMMARY
The Treasury announces the first 5 year TIPS tomorrow, Thursday, Oct 21
st
to be auctioned
on the 26
th
and settled on the 29th. The maturity of this issue will be 4/15/2010. We expect a
$10 bn new issue, which will be reopened next year in April and October. We are looking for
a total size of the issue (post both reopenings) to be around $22-24 bn.

The new 5 year does not look compelling from a real yield (outright or on the curve)
perspective. Also on the breakeven curve, 10s look more attractive than 5s. However, this
issue can attract demand from investors looking for a liquid intermediate TIP to express a
near term inflation view due to the recent uptick in oil. Also, the 1/10s have been setting up
for supply and 5 year breakevens are off the highs. Infact, the 5 year sector looks attractive
versus the very front end versus nominals . In addition, the negative seasonals going into
the end of the year should impact 5s less than the front end. Hence we would expect 5s to
outperform 2s coming out of the auction; but by the same logic, to under perform 10s going
into the end of the year. Thus, we think that the auction will probably come right at the
market.

ROLL COMPONENTS
1

We estimate the fair value of the roll (defined as the spread between new 4/10s and 1/10s) at
a pick 7 bps on announcement and settle. The par real curve between 1/15/10 and 4/15/10 is
worth about 4.7 bps. In addition, there is a sizeable coupon difference between the 1/10s (at
4.25%) and the new issue (assumed coupon of 1.125%), which contributes another 3.3 bp to
the roll. Given that October is a very low inflation accrual month (NSA CPI in August was up
only 0.05% month-on-month), carry from October 21st to 29th turns out to be less than half a
bp. Also, there are no bad days in the issue.

This issue should demand some premium for higher liquidity (than the 1/10s) especially as it
will be reopened twice next year. Also, there should be some premium for the fact that the
final maturity is April instead of January. This is important due to the seasonal impact on
inflation, wherein inflation tends to increase in the early part of the year. And finally, the
deflation put option has a higher value in this new 5 year (since 1/10s have about $12 of
premium already embedded in the principal). We attribute about 1-1.5 bp for the above
factors, and this should deduct from the roll. Thus, we get the fair value of the roll at 7-8 bp
at announcement and settle. See Figure 1 for the summary.

OUTLOOK FOR INFLATION
The inflation scare of the spring has faded despite the continued surge in energy prices and
this has been highlighted by the decelerating core CPI numbers since June this year. Core
CPI in September was up by a little more than expected 0.3%, but headline CPI remained
around expectations. The core component of PPI was up in September but that was mainly
driven by strong auto sales, a phenomenon which is expected in this part of the year and

1
We wish to thank Bruce Tuckman and Kodjo Apedjinou in our Interest Rate Modeling
group for their assistance.


Interest Rate Strategies


This document is for information purposes only. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers Inc. Under no circumstances should it be used or considered
as an offer to sell or a solicitation of any offer to buy the securities or other instruments mentioned in it. We do not represent that this information is accurate or complete and it should not be relied upon as such. Opinions
expressed herein are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, nor suitable for all types of investors; their value and the income they
produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors. Lehman Brothers Inc. and/or its affiliated companies may make a market or deal as principal in the securities
mentioned in this document or in options or other derivative instruments based thereon. In addition, Lehman Brothers Inc., its affiliated companies, shareholders, directors, officers and/or employees, may from time to time
have long or short positions in such securities or in options, futures or other derivative instruments based thereon. One or more directors, officers and/or employees of Lehman Brothers Inc. or its affiliated companies may be
a director of the issuer of the securities mentioned in this document. Lehman Brothers Inc. or its predecessors and/or its affiliated companies may have managed or co-managed a public offering of or acted as initial
purchaser or placement agent for a private placement of any of the securities of any issuer mentioned in this document within the last three years, or may, from time to time perform investment banking or other services for,
or solicit investment banking or other business from any company mentioned in this document. This document has also been prepared on behalf of Lehman Brothers International (Europe), which is regulated by the SFA.
2001 Lehman Brothers Inc. All rights reserved. Member SIPC.
how much of the increase in PPI feeds into CPI is debatable. Our Economists expect month
on month CPI to increase by 0.1% for October and November and a decline by 0.1% in
December (due to negative seasonals ). Thus the outlook for CPI looks fairly benign;
however the big question remains oil and energy impact on CPI. Any surge in inflation
should benefit the front end of the TIPS curve more than further out.

ON A BREAKEVEN BASIS
Consistent with the benign inflation readings of late, 5 year breakevens
2
(see Figure 2) have
come off the highs in summer this year, though they are still fairly high at about 230 bp. The
breakeven curve (Figures 3 and 4) in general, is extremely flat, a result of the near term
increase in inflation expectations (coinciding with rising oil prices) while continued faith in
the Fed to rein in inflation longer term. However, there is a negative seasonal pattern in
inflation going into the end of the year, which would hurt the front end. How the 2-5 year
breakeven curve (Figure 3) behaves should be a combination of the negative seasonals
dynamic and a potential energy price related surge in CPI. The flat nature of 5-10 year
breakeven curve (Figure 4) indicates however that 5s are expensive to 10s on the breakeven
curve.

REAL YIELD VALUATION
On the real curve, the 5 year sector looks rich. Figure 5 plots the yield of the 1/09s versus the
wings of the curve (1/07s and 1/14s), reflecting the richness of the 5 year sector in general.
However, this is not just a TIPS curve phenomena by the same historical analysis, 5s
look rich in nominal space as well.

AUCTION CONCESSION
It appears that the 1/10s have been setting up for supply for a while, as they have appeared
cheap on our models relative to neighbouring securities. Figure 6 plots the LIBOR OAS
spread differential between the 1/10s and the 1/09s, which has been flattening all through
September. This indicates that the 1/ 10s have been underperforming the 1/09s curve
adjusted seemingly making room for supply.

Figure 1: Disaggregating the Roll

Components Spread vs 1/10 (bp)
Real Curve 4.7
Coupon Effect 3.3
Liquidity/Deflation Put -1
Bad Days 0
Roll (Settle) 7
Carry 0.06
Roll (Announce) 7.06






2
Breakevens are defined as the spread between quoted (real ) yields of TIPS versus the
fitted yield to the nominal off the run Treasury curve


Interest Rate Strategies


This document is for information purposes only. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers Inc. Under no circumstances should it be used or considered
as an offer to sell or a solicitation of any offer to buy the securities or other instruments mentioned in it. We do not represent that this information is accurate or complete and it should not be relied upon as such. Opinions
expressed herein are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, nor suitable for all types of investors; their value and the income they
produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors. Lehman Brothers Inc. and/or its affiliated companies may make a market or deal as principal in the securities
mentioned in this document or in options or other derivative instruments based thereon. In addition, Lehman Brothers Inc., its affiliated companies, shareholders, directors, officers and/or employees, may from time to time
have long or short positions in such securities or in options, futures or other derivative instruments based thereon. One or more directors, officers and/or employees of Lehman Brothers Inc. or its affiliated companies may be
a director of the issuer of the securities mentioned in this document. Lehman Brothers Inc. or its predecessors and/or its affiliated companies may have managed or co-managed a public offering of or acted as initial
purchaser or placement agent for a private placement of any of the securities of any issuer mentioned in this document within the last three years, or may, from time to time perform investment banking or other services for,
or solicit investment banking or other business from any company mentioned in this document. This document has also been prepared on behalf of Lehman Brothers International (Europe), which is regulated by the SFA.
2001 Lehman Brothers Inc. All rights reserved. Member SIPC.

Figure 2: 5 year TIPS breakevens (rolling), bp
100
120
140
160
180
200
220
240
260
280
Jan-02 May-02 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04


Figure 3: Breakeven Spread Differential between 1/07s and 1/09s, bp
-10
-5
0
5
10
15
20
25
Jan-04 Mar-04 May-04 Jul-04 Sep-04










Interest Rate Strategies


This document is for information purposes only. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers Inc. Under no circumstances should it be used or considered
as an offer to sell or a solicitation of any offer to buy the securities or other instruments mentioned in it. We do not represent that this information is accurate or complete and it should not be relied upon as such. Opinions
expressed herein are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, nor suitable for all types of investors; their value and the income they
produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors. Lehman Brothers Inc. and/or its affiliated companies may make a market or deal as principal in the securities
mentioned in this document or in options or other derivative instruments based thereon. In addition, Lehman Brothers Inc., its affiliated companies, shareholders, directors, officers and/or employees, may from time to time
have long or short positions in such securities or in options, futures or other derivative instruments based thereon. One or more directors, officers and/or employees of Lehman Brothers Inc. or its affiliated companies may be
a director of the issuer of the securities mentioned in this document. Lehman Brothers Inc. or its predecessors and/or its affiliated companies may have managed or co-managed a public offering of or acted as initial
purchaser or placement agent for a private placement of any of the securities of any issuer mentioned in this document within the last three years, or may, from time to time perform investment banking or other services for,
or solicit investment banking or other business from any company mentioned in this document. This document has also been prepared on behalf of Lehman Brothers International (Europe), which is regulated by the SFA.
2001 Lehman Brothers Inc. All rights reserved. Member SIPC.

Figure 4: Breakeven Spread Differential between (rolling) 5s and 10s, bp

0
10
20
30
40
50
60
70
80
90
Jan-02 May-02 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04



Figure 5: Butterfly Spread, 1/07-1/09-1/14, bp
-40
-35
-30
-25
-20
-15
-10
-5
0
Jan-04 Mar-04 May-04 Jul-04 Sep-04







Interest Rate Strategies


This document is for information purposes only. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers Inc. Under no circumstances should it be used or considered
as an offer to sell or a solicitation of any offer to buy the securities or other instruments mentioned in it. We do not represent that this information is accurate or complete and it should not be relied upon as such. Opinions
expressed herein are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, nor suitable for all types of investors; their value and the income they
produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors. Lehman Brothers Inc. and/or its affiliated companies may make a market or deal as principal in the securities
mentioned in this document or in options or other derivative instruments based thereon. In addition, Lehman Brothers Inc., its affiliated companies, shareholders, directors, officers and/or employees, may from time to time
have long or short positions in such securities or in options, futures or other derivative instruments based thereon. One or more directors, officers and/or employees of Lehman Brothers Inc. or its affiliated companies may be
a director of the issuer of the securities mentioned in this document. Lehman Brothers Inc. or its predecessors and/or its affiliated companies may have managed or co-managed a public offering of or acted as initial
purchaser or placement agent for a private placement of any of the securities of any issuer mentioned in this document within the last three years, or may, from time to time perform investment banking or other services for,
or solicit investment banking or other business from any company mentioned in this document. This document has also been prepared on behalf of Lehman Brothers International (Europe), which is regulated by the SFA.
2001 Lehman Brothers Inc. All rights reserved. Member SIPC.

Figure 6: LIBOR OAS Spread Differential between 1/09s and 1//10s, bp
-4
-2
0
2
4
6
8
10
12
Jan-04 Mar-04 May-04 Jul-04 Sep-04















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Interest Rate Strategies


This document is for information purposes only. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers Inc. Under no circumstances should it be used or considered
as an offer to sell or a solicitation of any offer to buy the securities or other instruments mentioned in it. We do not represent that this information is accurate or complete and it should not be relied upon as such. Opinions
expressed herein are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, nor suitable for all types of investors; their value and the income they
produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors. Lehman Brothers Inc. and/or its affiliated companies may make a market or deal as principal in the securities
mentioned in this document or in options or other derivative instruments based thereon. In addition, Lehman Brothers Inc., its affiliated companies, shareholders, directors, officers and/or employees, may from time to time
have long or short positions in such securities or in options, futures or other derivative instruments based thereon. One or more directors, officers and/or employees of Lehman Brothers Inc. or its affiliated companies may be
a director of the issuer of the securities mentioned in this document. Lehman Brothers Inc. or its predecessors and/or its affiliated companies may have managed or co-managed a public offering of or acted as initial
purchaser or placement agent for a private placement of any of the securities of any issuer mentioned in this document within the last three years, or may, from time to time perform investment banking or other services for,
or solicit investment banking or other business from any company mentioned in this document. This document has also been prepared on behalf of Lehman Brothers International (Europe), which is regulated by the SFA.
2001 Lehman Brothers Inc. All rights reserved. Member SIPC.

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