Inflation-indexed bonds: a primer for finance officers.

• Author: Stumpp, Margaret

The hedging and diversification features of inflation-indexed bonds makes this relatively new investment instrument worth considering for public investors.

Inflation remains one of the greatest obstacles to achieving investment goals, despite its dormancy in recent years. Inflation robs fixed interest payments of purchasing power, thereby leading to a decline in the market value of bond portfolios. Inflation also increases the cost of many future liabilities, such as pension benefit payments. Simply put, inflation simultaneously erodes asset values and increases liabilities.

Until recently, only equities and real estate were considered capable of providing a hedge, albeit a crude one, against inflation. Today, however, the U.S. Treasury is one of several countries that issue inflation-indexed bonds. Inflation-linked bonds issued by the U.S. Treasury are commonly known as TIPS, for "Treasury Inflation Protected Securities." Inflation-protected bonds offer investors a high quality investment tool to hedge against inflation. Their outstanding diversification qualities also make them an ideal addition to many portfolios, even when inflation is not a concern.

A Short History of Inflation-Indexed Bonds

History shows that, when faced with rapidly accelerating inflation, investors at times have rejected conventional sovereign debt. Under such circumstances, governments have been forced to consider alternative forms of financing, including inflation-indexed debt, to regain investor confidence. Israel issued inflation-indexed bonds in response to double-digit inflation in 1955, and the United Kingdom did the same in the mid 1970s. Several Latin American governments have issued inflation-indexed bonds in environments when inflation rose to triple digits.

While other nations have been forced to issue inflation-indexed bonds in response to economic upheavals, the U.S. Treasury surprised investors in 1997 by issuing inflation-indexed bonds at a time of economic stability. (Their use, however, actually began much earlier: inflation-indexed debt was used in this country in colonial times.) Although U.S. investors were slow initially to embrace these securities, interest has steadily increased as investors have become aware of their unique advantages. As of this writing there are 10 U.S. Treasury issues outstanding, ranging in maturity from four to 30 years.

Cynics contend that governments have an incentive to create inflation, because it reduces the cost of repaying outstanding national debt. Because inflation cannot erode the value of inflation-indexed bonds, a government issuing such bonds emphasizes its commitment to fighting inflation, with the mere existence of the bonds a positive signal. Both issuers and investors have the potential to benefit from them: investors benefit from their hedging and risk management capabilities, while governments can reduce the cost of carrying the public debt provided they successfully restrain inflation.

How Do Inflation-Indexed Bonds Work?

The precise provisions of inflation-indexed bonds vary around the world. In the United States, they are government-issued securities for which the outstanding principal is adjusted in response to changes in the consumer price index. Mechanically, this adjustment is made by modifying the face or par value of the bond to reflect changes in the CPI relative to a base level. Once the par value is adjusted, the corresponding semi-annual interest payments automatically change to compensate for the higher CPI. Consider a hypothetical $1,000-par inflation-indexed bond with a 3 percent coupon rate. This bond would initially pay $30 per year in interest. If the CPI were to double, the bond's value would increase to $2,000 and the interest payment would also double to $60.

Not surprisingly, the precise formula is slightly more complicated. Economists have long known that yields on conventional bonds are comprised of several components, as characterized in the fob lowing simplified expression:

Conventional Bond Yield = Real Yield + Expected Inflation + Risk Premium

Putting aside the more theoretically thorny (and presumably smaller) component of the "risk premium," real yield and expected inflation represent the two...