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Inflation-Indexed Security

Inflation-Indexed Security
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What Is an Inflation-Indexed Security?

An inflation-indexed security is a security that guarantees a return higher than the rate of inflation assuming it is held to maturity. Inflation-indexed securities interface their capital appreciation, or coupon payments, to inflation rates. Investors seeking safe returns with next to zero risk will frequently hold inflation-indexed securities. A common model are Treasury Inflation-Protected Securities, or TIPS.

An inflation-indexed security is otherwise called an inflation-linked or a real return security.

How an Inflation-Indexed Security Works

An inflation-indexed security has its principal indexed to the Consumer Price Index (CPI), or some other nationally recognized inflation index, consistently. The CPI is the proxy for inflation that measures price changes in a basket of goods and services in the U.S. furthermore, is distributed month to month by the Bureau of Labor Statistics (BLS).

By connecting a security to inflation, the principal and interest income received by investors are protected from the erosion of inflation. For example, consider a bond that pays 3% when inflation is 2%. This bond will yield just 1% in real terms, which is unfavorable for any investor living on a fixed income or pension.

The market for inflation-indexed securities will in general be illiquid, as the market is comprised to a great extent of purchase and-hold investors.

Benefits of an Inflation-Indexed Security

Despite the fact that inflation is normally terrible for the profitability of any fixed-income instrument, as it frequently causes interest rates to rise, an inflation-indexed security guarantees a real return. These real return securities normally come as a bond or note, however may likewise come in different forms. Since these types of securities offer investors an extremely high level of safety, the coupons joined to such securities are regularly lower than notes with a higher level of risk. There is generally a risk-reward tradeoff for investors to balance. The periodic coupon on inflation-indexed securities is equivalent to the product of the daily inflation index and the nominal coupon rate. An increase in inflation expectations, real rates, or both, brings about a rise in coupon payments.

Inflation-indexed securities give a generally safe investment vehicle in which the return is guaranteed not to fall below the rate of inflation. Aside from TIPS bonds, the market for these securities is comprised principally of buy-and-hold investors. Accordingly, the market for inflation-indexed securities is decently illiquid.

In the United Kingdom, inflation-linked gilts are issued by the U.K. Debt Management Office and linked to that nation's retail price index (RPI). The Bank of Canada issues that country's real return bonds, while Indian inflation-indexed bonds are issued through the Reserve Bank of India (RBI).

Inflation-linked bonds were first developed during the American Revolution to combat inflation's destructive effects on the real value of consumer goods in the provinces during the war.

Illustration of an Inflation-Indexed Security

The federal government offers several types of inflation-indexed investments, two of which are the Series I U.S. Savings Bond and Treasury Inflation-Protected Securities (TIPS). For instance, a $1,000 TIPS is issued with a 2.5% coupon rate to be paid semi-annually. The inflation rate is 3% accumulated semi-annually and the bond develops in 5 years.

The coupon rate per period is 1.25% (2.5%/2). The main semi-annual payment will be made on the principal value adjusted for inflation, which is $1,015 ($1,000 x (1 + 3%/2). The interest paid, consequently, is $12.69 (1.25% x $1,015) the initial six months. Note that without accounting for inflation, the investor would receive $12.50 (1.25% x $1,000).

At the hour of maturity — year 5 or period 10 — the value of the principal adjusted for inflation will be $1,160.54 ($1,000 x (1 + 3%/2)^10). The last coupon payment to be made in period 10 will be $14.51 ($1,160.54 x 1.25%).

In this way, while the interest rate stays fixed at 2.5% each year, the dollar value of each interest payment will rise, as the coupon will be paid on the inflation-adjusted principal value. Be that as it may, on account of the Series I Savings bond, the interest rate on the bond changes since it is adjusted by daily inflation. On the off chance that inflation increases, the interest rate on the savings bond will be adjusted upwards. During periods of deflation, the bonds are guaranteed to never drop below 0%.

Highlights

  • Given the safety of these securities, coupons on inflation-indexed securities generally offer lower coupons than other higher-risk notes.
  • TIPS and a large number of their global inflation-linked partners don't offer excellent protection during times of deflation
  • Inflation-indexed securities guarantee a return that is greater than inflation, frequently indexed to the Consumer Price Index (CPI) or another inflation index.
  • The inflation-indexed security shields an investor's returns from the erosion of inflation, guaranteeing a real return.