Inflation Linked Bond Summary

INFLATION-LINKED BONDS

Inflation is the key driver of investment performance. It determines how much each dollar of return is worth, and it dictates asset returns themselves. Falling raw materials prices allowed corporate margins to expand. Simultaneously, falling interest rates had a positive impact on the price-to-earnings multipliers being applied to those expanded corporate earnings. For different reasons, the inflation-adjusted returns of bonds and cash similarly were favourably affected by falling inflation during this period. The opposite happens during bouts of rising inflation. Investors have found a weapon that effectively offsets this threat to stable and predictable investment returns which is TIPS (Treasury Inflation Protection Securities).

TIPS (Treasury Inflation Protection Securities)1 are bonds that promise to protect and grow investors' purchasing power. The principal of TIPS based on changes in the consumer price index (CPI). Maintains the purchasing power of the stream of semi-annual interest payments by calculating coupon payments based on the CPI-indexed principal amounts. Inflation-indexed securities account for more than 20% of government bonds outstanding.

TIPS are best known as a defensive hedge against the fear of inflation, but they offer tactical and strategic advantages as well. Tactically, investors are attracted to the opportunity TIPS afford to speculate on changes in inflation and real interest rates. Strategically, individual and institutional investors with long term objectives are attracted to TIPS high real yield, low correlation to traditional financial assets, and muted volatility. They sense TIPS will help them to achieve their long-term investment goals and reduce risk in the process. The unique characteristics of TIPS qualify them as a fundamental asset class, as are equities, traditional bonds, and cash & their novelty and scope attest to their importance as an investment instrument.

This chapter has two goals; the first and most important is to introduce market participants to this important new investment instrument. The second is to provide portfolio managers with a comprehensive examination of the investment qualities that make TIPS unique.

MECHANICS AND MEASUREMENT

How TIPS Work

The merit of TIPS

The principal and interest repaid to investors fluctuates based on the level of the CPI,

The purchasing power of each payment is fixed

The real yield of TIPS is fixed.

The Treasury calculates the amount of each coupon payment, after the principal has been adjusted for inflation.

TIPS pay interest semi-annually at one-half their stated annual coupon rate. The inflation-indexed principal is accrued daily, based on an interpolation between the two most recent monthly CPI figures reported prior to the settlement month.

Treasury uses a rather arcane rounding procedure for interim and final calculations.

The Consumer Price Index (CPI)

Non-Seasonally Adjusted, All-Urban Consumer Price Index (NSA CPI-U)

* reported monthly

* not subject to revision

* series includes predictable seasonal fluctuations in inflation

* measures the price level in a given month

* allows for potential delays in the official release of the CPI

* eliminates the need to calculate day counts across month-end

* CPI reports into TIPS indexation is described as a three-month lag

* To calculate the TIPS principal for any settlement date other than the first of a month

Real Frame of Reference, Real Yield, Nominal Yield, and Break-Even Inflation Rate

Real Frame of Reference

A nominal frame of reference looks at investments in terms of dollars, without regard for any change in purchasing power of those dollars. In contrast, a real frame of reference takes into account the loss of purchasing power due to inflation.

Any investment can be described from either a real or nominal frame of reference. To directly compare the expected returns of any two investments, one must choose either a real or a nominal frame of reference.

Real Yield

The real yield of a TIPS bond represents the annualized growth rate of purchasing power earned by holding the security to maturity. The real yield of a nominal bond is more difficult to calculate because it can be precisely determined only with the benefit of hindsight.

In practice, when analysts speak of a nominal bond's real yield, they may be

(1) Referring to its "current" real yield,

(2) "Guesstimating" the nominal bond's "expected" real yield based on expectations of future inflation,

(3) Speaking of historical realized real yields on bonds that have matured.

Nominal Yield

The nominal yield realized by holding TIPS to maturity depends on the average level and trajectory of inflation over the bond's lifetime. Ignoring the trajectory of the inflation rate, and focusing only on the average level of inflation,

TIPS realized nominal yield  (1 real yield)  (1 inflation) 1

Break-Even Inflation Rate

The break-even inflation rate is the rate that results in the holder of a TIPS "breaking even" with the holder of a nominal bond.

Break-even inflation rate (1 conventional nominal yield) / (1 TIPS real yield) 1

Although the break-even inflation rate may be useful to assess market inflation expectations or to gauge break-even requirements for narrowly constrained fixed income investors, it generally overstates the risk-adjusted breakeven inflation rate applicable to long-term strategies.

Because TIPS pay in real