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Right now, inflation in the developed world is low. In fact, this is one of the reasons central banks in the developed markets have kept interest rates extremely low, or even negative, since the financial crisis of 2008.

However, monitoring and potentially protecting against inflation remains a key element for both central bankers and investors. Both because changes in inflation could lead to changes in monetary policy and because, ultimately, all investors are exposed to inflation. One very direct way investors can protect against inflation is to buy government issued inflation linked bonds.  Overall, there is around USD1,500 billion worth of these instruments in issue globally!

The most common inflation linked bonds are TIPS, Treasury Inflation Protected Securities, issued by the US treasury. There are around USD500 billion worth of TIPS in issue. Let’s have a closer look at TIPS in order to understand the basics (inflation linked bonds issued by other countries work in a similar fashion):

TIPS are issued with a set face value of say USD1,000 and a set coupon rate (paid semi-annually). At the issuance of the bond, the Consumer Price Index (CPI) is recorded. As the CPI changes during the life of the bond, the face value is adjusted. If CPI rises by 2% (i.e. there is 2% inflation), then the face value of the TIPS increases by 2% to USD1,020 and coupons are paid based on this higher amount. Once the bond matures, the face value returned to the investor is also adjusted by the change in CPI. In the unlikely event of deflation i.e. CPI going down, coupon payments are adjusted down while the face value at maturity is floored at the original level. In other words, coupon payments are exposed to deflation, while principal is not.

So, TIPS protect against inflation. What interest rate should we expect to receive if we invest in TIPS? Well, normal bonds have a yield, the nominal interest, that reflects expected inflation and real yield. In TIPS, we remove the inflation uncertainty as the investor is compensated for inflation, so the yield will be lower by the expected inflation. In other words, the interest rate on TIPS is the real interest rate. If normal US government bonds are trading at say a yield of 3% and the same maturity TIPS is trading at 1%, it suggests to us that investors are expecting inflation to be 2% during the life of the bond (and that real interest rates are 1%). In fact, this difference in yield is perhaps the best way to see what inflation level markets expect.

The difference in yield between the TIPS and the normal bonds (the 2% in this example) is known as the break-even inflation. This means that if realized inflation during the life of the TIPS is 2% an investor in TIPS break even, getting the same return as an investor in a normal bond. If inflation is higher than 2%, then the investor makes money compared to the investor in a normal bond.

Below we show the current yield on the on-the-run US Treasury 10 year bond and the yield on the 10 year TIPS. Current 10-year break even inflation is 1.58%.

Yield
10 Year US Treasury Bond 1.69%
10 Year TIPS 0.11%
BEI (Break Even Inflation) 1.58%

Worried about inflation? Keep an eye on those TIPS!

The FICC Trader Online