Inflation Bonds

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Inflation Bonds

On January 29, 1997 the U.S Treasury’s first ever offering of debt designed to protect the investors from inflation was a huge hit as consumers placed bids for $37.2 billion of the securities– five times the amount offered. The $7billion of 10-year inflation indexed the notes were auctioned at an annualized fixed yield of 3.449% which by the end of trading was down to 3.38%.

The 10-year inflation indexed bonds are most often called Treasury Inflation Protection Securities, or TIPS. The fixed annual yield on standard 10-year Treasury notes was at 6.62%.

The Relationship Between The Return on these bonds

You should distinguish between two types of yields ( I.e., the yield to maturity ( YTM). The coupon rate, set when bonds are issued, determines the fixed cash flows to be received by the investor over the life of the bond, while the YTM represents the opportunity cost, also referred to as the rate required or expected rate of return.

What Is The Governments Motivation For Issuing Them?

The governments proposal is to make the coupon rate fluctuate with inflation. This type of cash money flow arrangement is analogous to an adjustable rate mortgage. So what should such a feature do to the price of bonds?

It should, other things being comparable, reduce the suspicion associated with the future inflation that investors face. But a lower uncertainty means lower IP. Ultimately, this would mean the YTM would be lower. When the government issues these bonds, investors will always require a lower financing rate than a similar bond. This is because they do not have an inflation protection feature. Without a doubt, the lower financing charge should have the government some money and lower its deficit.

This feature however does not guarantee a lower YTM for a given maturity date. This is because of the liquidity of these bonds. In general, U.S Treasury bonds are very liquid; the associated LP is zero. Since these bonds are new, and if investors use them as a retirement investment vehicle, then there may not be enough demand or supply for these bonds at all times. If this turns out to be the case, then investors are going to need a higher LP, pushing the YTM up. The government is aware of this and this will remain a major factor in determining the amount to be issued.

Who Will Buy Them?

The government is targeting them as new retirement investment vehicles. Investors who are worried about inflation eroding the value of their investment will have a way to keep there bond values safe against inflation.

Remember if inflation increases, or if its expected to increase, then IP increases, the leading to a higher YTM. YTM and bond prices are inversely related; when YTM increases, the price of the bond lowers. Ultimately, ow will these bonds protect their investors?

The coupon rate, which determines the size of the periodic cash flows paid to the bondholders, is not fixed; its tied to the inflation rate. So when the YTM increases as a result of an increase in inflation, so does the cash flows, thus offsetting each other and leaving the price of the bond unaffected by changes in inflation.