Inflation Protected Bonds

Treasury inflation-protected securities (TIPs) are one of the most innovative financial products to appear in recent years. They pay a real coupon, plus the return on the Consumer Price Index (CPI). Thus, they automatically protect investors 100% against rising inflation, a property no other security possesses. Further, in a rising inflation environment, returns on TIPs are negatively correlated with those of bonds and other assets whose prices tend to decline when inflation rises. 

Index-linked or inflatiOTi-indexed bonds present additional issues in their analysis, due to the nature of their cash flows. Measuring the retimi on index-linked bonds is less straightforward than with conventional bonds, and in certain cases there are peculiar market structures that must be taken into accotmt as well. For example, in the United States market for index-linked treasuries (known as TIPS from Treasury Inflation-Indexed Securities) there is no significant lag between the inflation link and the cash flow payment date. In the United Kingdom, there is an 8-month lag between the inflation adjustment of the cash flow and the cash flow payment date itself, while in New Zealand there is a 3-month lag. The existence of a lag means that inflation protection is not available in the lag period, and that the return in this period is exposed to inflation risk it also must be taken into account when analysing the bond. 

In a deflationary environment a conventional bond performs very well, while an inflation-linked bond gives negative returns. Some of inflation-linked bonds include deflation protection.In practice, in the event of deflation, the bondholder will receive at maturity the par value although the redemption value is less than 100. Therefore, the bondholder will obtain at least the par value. Note that the deflation floor applies to the redemption value only leaving coupon payments exposed to the deflation risk. 

For example, inflation-linked bonds issue in the United States, Italy, France, Sweden and Germany. Note that inflation-linked bonds issue in the United Kingdom does not include deflation protection. 

As described above, inflation-linked bonds allow to save investors from changes in the general level of prices. However, the indexation is not perfect creating a lag between the index prices and the adjustment to the bond cash flows. According to Deacon and Derry (2004) at the end of a bond s life there is no inflation protection, matched with an equal period before the issue in which the inflation compensation is paid. Figure 6.11 shows an example of indexation lag according to Deacon and Derry (2004). 

Needless to say, we do not live in a two-asset world, and this complicates matters further. An investor might place a high inflation risk premium on an index-linked bond when only nominal alternatives are available, but the value attributed to the risk premium will also be influenced at least a little by the availability of competing assets offering some degree of inflation protection—the more classic inflation hedges such as real estate and land. 

The Eurozone IL swap market started trading in May 2001, months before the Tresor issued the first Eurozone IL bond, the OATei 2012. The introduction and hedging of retail inflation protected equity products (e.g., those issued by the Italian Post Office and others) helped to kick off activity in the interbank Eurozone IL swap market, which has seen a steadily increasing uptrend in volumes traded per month. As of May 2003, pension related IL swaps and swaps from corporate payers are still a rarity, however some infrastructure driven hedging is taking place. 

Duration increases as coupon and yield decrease. The lower the coupon, the greater the relative weight of the cash flows received on the maturity date, and this causes duration to rise. T ong the non—plain vanilla types of bonds are some whose coupon rate varies according to an index, usually the consumer price index. Index-linked bonds generally have much lower coupons than vanilla bonds with similar maturities. This is true because they are inflation-protected, causing the real yield required to be lower than the nominal yield, but their durations tend to be higher. 

Treasury Inflation-Protected Security (TIPS) A security that is identical to a Treasury bond except that principal and coupon payments are adjusted to eliminate the effects of inflation. 

One final point regarding duration is that it is possible to calculate a tax-adjusted duration for an index-linked bond in markets where there is a different tax treatment to indexed bonds compared to conventional bonds. In the United States market, the returns on indexed and conventional bonds are taxed in essentially the same manner, so that in similar fashion to Treasury strips, the inflation adjustment to the indexed bond s principal is taxable as it occurs, and not only on the maturity date. Therefore, in the US-indexed bonds do not offer protection against any impact of after-tax effects of high inflation. That is, Tips real yields reflect a premium for only pretax inflation risk. In the United Kingdom market however, index-linked gilts receive preferential tax treatment, so their yields... 

To provide precise protection against inflation, interest payments for a given period would need to be corrected for actual inflation over the same period. Lags, however, exist between the movements in the price index and the adjustment to the bond cash flows. According to Deacon and Derry (1998), such lags are unavoidable for two reasons. First, inflation statistics for one month are usually not known until well into the following month and are published some time after that. This causes a lag of at least one month, as shown in FIGURE 12.3. Second, in some markets the size of a coupon payment must be known before the start of the coupon period in... 

---