How do inflation indexed bonds work

This relates to the difference between the nominal yield of a nominal bond and that of an indexed bond with equivalent maturity issued by the same government. As already mentioned, the nominal yield of an inflation-linked bond is often lower than that of a nominal bond, as an additional amount of interest is related to the inflation rate. By calculating breakeven inflation, investors receive an inflation rate that must be achieved over the life of a bond, in order that the indexed bond equals the nominal bond.

Here an example of how one-year breakeven inflation levels have moved in the US, UK and Europe over the past 10 years.

The concept of breakeven inflation rates comes into play when considering the long-term yield of an inflation-indexed bond as well as the annual expected rate of inflation. From a tactical point of view, when buying and selling a bond over a shorter period, carry is a key factor: it represents the gain or loss that investors bear over their investment period depending on whether they choose to retain the security in this case the inflation-indexed bond or to invest in a risk-free security.

In simple terms, when comparing a risk-free security with the same maturity as the inflation-linked bond, carry reflects the gain or loss realised on the coupons in the case of positive or negative inflation, respectively. Whatever the inflation index used as a benchmark for the bond, the structure of inflation-linked bonds cannot be based upon a snapshot inflation rate.

Indeed, as gathering price information is a fairly lengthy process, it is essential to take into account this gap between the publication of the index and the period that it covers when evaluating the inflation-linked bond — for instance, the value of a price index for the month of July, will not be published until sometime in August. In addition to the timing of the publication of the index and the payment dates of the coupon, seasonal variations also play a role.

This implies that TIPS holders are not benefiting from a discount, but it still implies that the Treasury could raise more revenue by issuing nominal bonds instead of TIPS. Of course, revenue maximization need not be the only reason for a government to issue bonds. The government can contribute to improve social welfare by completing markets. My research on the key role of TIPS on the portfolios of long-term investors, such as individual investors saving for retirement, shows that issuing TIPS can be welfare enhancing.

The shift in the provision of pension benefits in the US from defined benefit to defined contribution suggests that the importance of TIPS for savers has, if anything, increased over time. Campbell and L. Wachter, "Risk aversion and allocation to long-term bonds," Journal of Economic Theory , October Lusardi, ed. Gomes, L. Kotlikoff, and L. This is an updated version of Figure 1 in J.

Campbell, R. Shiller, and L. Sunderam, and L. Viceira, "Inflation Bets or Deflation Hedges? This is an updated version of Figure 1 in L. See also J. See Figure 7 in J. Campbell and J. Cochrane, "By force of habit: a consumption-based explanation of aggregate stock market behavior. Wachter, "A consumption-based model of the term structure of interest rates," Journal of Financial Economics , February Campbell, A.

Cochrane and M. Piazzesi, "Bond risk premia," American Economic Review 95, —, Campbell and R. Bansal and I. Pflueger and L. D'Amico, Stefania, Don H. Wright, R. Fleckenstein, F. Longstaff, and H. Luis M. He is also the George E. Bates Professor at the Harvard Business School, where he has been in the faculty since He received his M. Viceira is a financial economist interested in the study of asset allocation models, with an emphasis on models that explore the asset allocation implications of empirical regularities in asset pricing and on life-cycle investing, asset pricing, with an emphasis on models of the term structure of interest rates, household finance, and international finance.

Viceira is also interested in the design of pension fund systems, the design of investment strategies for long-term investors, the management and organization of large institutional investors, and product innovation in the money management industry.

He loves swimming, skiing, and reading history and fiction. NBER periodicals and newsletters are not copyrighted and may be reproduced freely with appropriate attribution. More in this issue. The Reporter: No. Share Twitter LinkedIn Email. Introduction Inflation-linked bonds, which in the United States are known as Treasury Inflation Protected Securities or TIPS , are bonds that pay investors a fixed inflation-adjusted coupon and principal.

Inflation-Indexed Bonds in Long-Term Portfolios A traditional idea in investment practice is that cash for example, short-term default-free bonds or bills is the safe asset for all investors.

About the Author s. Also in this issue:. International Mobility of Research Scientists. Program Report: Productivity, Innovation and Entrepreneurship.

You should also consider market price at the end of your time horizon. For example, even when inflation exceeds the breakeven rate over a year or two, traditional bonds would still beat ILBs if they are trading at higher prices. Unlike their U. That makes their holders susceptible to a capital loss at maturity if deflation persists. Another pitfall lies in their typically long maturities with some RRBs extending over 20 years. The longer the duration to maturity, the more volatile a bond becomes when interest rates fluctuate.

Any inflation compensation on the principal and the interest payments are taxed in the year they occur even though the principal is only paid upon maturity. But holding them inside a registered account eliminates those issues. A final point to remember is not to lose sight of your investment goals when deciding between an RRB and a traditional bond. However, that hedge could come at the expense of more volatility. Looking for tips on how to build a diversified portfolio? Just like nominal bonds, whose prices move in response to nominal interest rate changes , ILB prices will increase as real yields decline and decrease as real yields rise.

Should an economy undergo a period of deflation — a sustained decline in price levels during the life of an ILB, the inflation-adjusted principal could decline below its par value. Subsequently, coupon payments would be based on this deflation-adjusted amount. However, many ILB-issuing countries, such as the U. So, while coupon payments are paid on a principal adjusted for inflation or deflation, an investor receives the greater of the inflation-adjusted principal or the initial par amount at maturity.

To compare ILBs with nominal government bonds and determine their relative value, investors can look at the difference between nominal yields and real yields, called the breakeven inflation rate. The difference indicates the inflation expectations priced into the market; it is the rate differential at which the expected returns of ILBs and nominal bonds are equal. If the actual inflation rate over the life of the bond is higher than the breakeven inflation rate, investors would earn a higher return holding ILBs while having lower inflation risk.

If the actual inflation rate is lower than expectations, the nominal bond of the same maturity would garner a higher return, though with a higher inflation risk. For example, if a year nominal UK gilt is yielding 2.

If an investor believes the UK inflation rate will be above 2. As with other investments, the price of ILBs can fluctuate, and if real yields rise, the market value of an ILB will fall. Real yields can rise, without a corresponding increase in nominal yields. If held to maturity however, the market value fluctuations are irrelevant and an investor receives the par amount.

In theory, a period of deflation could reduce this par amount. However, in practice most ILBs are issued with a deflation floor to mitigate this risk. Through its monetary policy tools, the Fed works to encourage full employment and stabilize prices. A word about risk: All investments contain risk and can lose value.

Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk.