Features and risks of Treasury inflation protection securities

Federal Reserve Bank of Kansas City - Economic Review, First Quarter 1998 by Shen, Pu

In 1997, the U.S. Treasury began the quarterly issuance of inflation indexed bonds, called Treasury Inflation Protection Securities (TIPS). So far, the Treasury has issued both 5-year and 10-year indexed bonds and will begin to issue 30-year indexed bonds and inflation indexed savings bonds in 1998. TIPS differ from conventional Treasury bonds in both their payment flows and risks. With virtually no inflation risk, they are the safest assets currently available in the U.S. market. Combined with conventional Treasury bonds, they allow investors to separate inflation risk from real interest rate risk and thus manage risk more efficiently.

To help investors understand and take full advantage of these new securities, this article discusses the features and risks of the Treasury inflation indexed bonds. The first section of the article discusses the features of inflation indexed bonds. The second section explains why these bonds can benefit many investors. The third section shows how the tax code prevents these bonds from being entirely inflation-risk free. Finally, the article shows that historically the market risk of an indexed bond has been small compared to that of a conventional bond with similar maturity.

I. FEATURES OF TREASURY INFLATION PROTECTION SECURITIES

The U. S. government has accumulated approximately $5 trillion in debt due to years of deficit financing.1 Most of this debt is borrowed in the form of Treasury securities, which can be traded (changing ownership) among investors before they mature. TIPS are a special form of Treasury securities because their principal and coupon payments are indexed to inflation, while most other Treasury securities are not. In this article, they will often be called indexed bonds, whereas the non-inflation-indexed Treasury securities are referred as conventional bonds or nominal bonds.2

What are indexed bonds?

While both indexed and conventional bonds pay interest semiannually and principal at the time of maturity, the pattern of the payments of indexed bonds is unique. The nominal (dollar) payments of a conventional bond, including both coupon interest and the principal, are fixed at the time of issuance. In contrast, both the coupon interest and the principal of an indexed bond are fixed in real terms, that is, in terms of purchasing power. The dollar payments of an indexed bond are adjusted according to the actual inflation during the life of the bond.

Table 1 shows the payments of hypothetical 5-year indexed and nominal bonds, each with $1,000 par value. The table assumes that interest on the bonds is paid annually, at the end of each year. The real coupon rate on the indexed bond is 3.5 percent, and the nominal coupon rate on the conventional bond is 5.5 percent. The table shows how the dollar payments of the indexed bond are adjusted in three different (yet constant) inflation scenarios. In the first scenario, the actual annual inflation, pi, is zero; in the second scenario, actual inflation equals 2 percent, which is the market expected rate of inflation; and in the third scenario, actual inflation is 4 percent.

The numbers in the table are calculated as follows. For the nominal bond, the calculations are straightforward since both the par value and the coupon payments are fixed in nominal terms. The par value is fixed at $1,000 and the coupon payment is fixed at $55 ($1,000 times 5.5 percent) per year. For the indexed bond, it is straightforward to calculate the real values of the par and coupon interest since they are fixed in real terms. The real value of the par is fixed at $1,000 and the real value of the coupon payment is fixed at $35 ($1,000 times 3.5 percent). The calculation of the inflation-adjusted coupon payments, however, requires first calculating the inflationadjusted principal at the end of each year, which equals the dollar value of the principal at the beginning of the year times 1 + pi, with pi being the actual inflation rate during the year. The dollar coupon payment of the indexed bond at the end of a given year is then calculated by multiplying the inflation-adjusted principal by the coupon rate. For example, the far right cell in the first row shows that if inflation is 4 percent, the inflation-adjusted principal is equal to $1,040 ($1,000 times 1.04) at the end of the first year, and the coupon interest is equal to $1,040 time 3.5 percent, which is $36.40. At the end of the fifth year, both bonds mature, thus their principals are paid back to investors. The conventional bond pays $1,000 in nominal terms, and the indexed bond pays $1,000 in real terms. The dollar amount of the principal actually paid is the real principal times the accumulated inflation over the life of the bond. In the scenario of 4 percent inflation, for example, the nominal principal is $1,000 times (1.04)5, or $1,216.65. Table 1 highlights two major features of indexed bonds. First, the real values of the interest payments are constant under all inflation scenarios during the life of the bond, while the nominal values rise with the actual inflation rate. As a result, the real yield of holding an indexed bond to its maturity is invariant to actual inflation. This is why indexed bonds are called inflation protection securities: they protect investors from inflation.3 In comparison, the interest payments of a conventional bond are constant in nominal terms but decline in real terms since inflation erodes the purchasing power of fixed payments over time. Further, while the nominal yield of holding a conventional bond to its maturity is fixed, the real yield depends on the actual inflation rate during its life. The real yield on a nominal bond, y^sup real^, is roughly equal to its nominal yield, y^sup nominal^, minus actual inflation, pi.4 That is, y^sup real^ = y^sup nominal^ - pi. Hence, the real yield of a conventional bond varies inversely with actual inflation: the higher actual inflation is, the lower the real yield will be.