Inflation‐linked bonds were first issued by the United States Treasury Department in 1997. They are designed to provide investors with an asset that compensates them for inflation. The principal of those bonds is indexed to the consumer price index (CPI). Interest payments are also effectively indexed through the application of a fixed interest rate to the indexed or adjusted principal. Inflation‐linked bonds appeal to a variety of investors, including pension funds, many of which have to make payments tied to the rate of inflation. In addition, inflation‐linked bonds provide diversification for investors who hold other assets such as equities and conventional bonds.

Inflation‐linked bonds are popularly known as TIPS (Treasury inflation‐protected securities) in the United States. As of the end of 2015, public holdings of TIPS totaled $1.168 trillion. Gross issuance was $155 billion in 2015.¹ In recent years, the Treasury Department has issued TIPS with maturities of 5, 10, and 30 years. In spite of the growth of the volume of TIPS outstanding, the market for inflation‐linked remains less liquid than for conventional Treasury bonds. Trading activity for TIPS tends to spike in conjunction with auction results and the release of data on the consumer price index.

INDEXATION

The bonds are indexed to the non–seasonally adjusted consumer price index (NSA CPI). The non–seasonally adjusted index is used because it is not subject to revision. The seasonally adjusted CPI is revised periodically as seasonal adjustment factors get recalculated. The use of the NSA CPI for indexing purposes introduces a seasonal pattern to how fast the principal for TIPS increases. Increases for the NSA CPI tend to be quite rapid in March through May and slow or even negative during the months in the second half of the year. A significant part of the seasonality in the NSA CPI is due to patterns seen in retail gasoline prices, which tend to rise sharply in the spring.

When the NSA CPI declines for a given month, the principal of TIPS issues also declines. At maturity, if the inflation‐adjusted principal is less than the security's original principal, the investor will be paid the original principal. This provides some limited protection in the event of deflation. It should be noted, however, that the track record of the CPI suggests that deflation over a multiyear period is fairly unlikely. Over the 25‐year period ending in 2015, the average annual increase for the CPI was 2.4%.²

The change in principal is calculated daily. The rate of increase over a given month is based upon how much the NSA CPI increased two months earlier. For example, the increase in the value of the principal over the course of July is determined by how much the CPI increased in May. This two‐month lag structure is needed because the May CPI is the last CPI report available before July 1. CPI reports for a given month are typically released in the third week of the next month. So the May CPI will typically be released in the third week of June and will determine accretion (the growth rate) of the principal on each TIPS issue from July 1 to July 31. Using the data for the NSA CPI the Treasury Department publishes an index ratio for each TIPS issue. The index ratio is calculated for each day and reflects how much the principal has grown since issuance.

Mathematically, the index ratio for a particular TIPS issue can be expressed as follows:

where is the index ratio on day , is the reference CPI on day , and RCPI (0) is the reference CPI for the issue in question on its issue date. As we noted, there is a lag structure between the NSA CPI and the reference CPI. For example, the reference CPI on July 1 is the April NSA CPI and the reference CPI on August 1 is the May NSA CPI. For the 31 days between July 1 and August 1 the reference CPI changes by 1/31 of the difference between the April and May NSA CPI. The value of the principal on any given day is its value when issued times the index ratio for that issue on that day.

TIPS issues pay interest twice a year. The interest rate is announced by the Treasury Department prior to the auction of each issue and reflects market conditions in the period ahead of the auction. It is applied to the value of the principal. For example, if July 15 is the date for one of the two annual interest rate payments, the interest rate is applied to the value of the principal for that date.

REAL YIELDS AND INFLATION BREAKEVENS

Investors and traders who are active in the TIPS market pay close attention to the inflation breakeven for each issue. The inflation breakeven is the difference in interest rate of nominal Treasury bond (nominal yield) and the interest rate of a TIPS issue of similar maturity. For example, a five‐year Treasury might have a yield of 3% while five‐year TIPS are yielding 1%. The breakeven inflation rate is 2%, meaning that inflation has to rise by at least 2% per year over the remaining life of the issue for the return on TIPS to exceed that on the nominal Treasury. It should be noted that the inflation breakeven is not a pure measure of inflation expectations since it also incorporates other factors such as liquidity premia.

A trader or investor might form a judgment that the breakeven on inflation‐linked bond is cheap, meaning that he or she expects inflation to exceed the inflation breakevens implied by current rates. If, for example, the investor expects inflation to average 2.5% while inflation breakevens stood at 2%, he or she would have an interest in owning TIPS rather than nominal Treasuries.

The Federal Reserve maintains constant maturity series for breakeven inflation for 5‐year and 10‐year TIPS. Figure 12.1 shows the 10‐year series. It shows the average annual increase in the CPI over a 25‐year period (1990–2015).

As the graph shows, there are periods when inflation breakevens in the 10‐year sector fluctuate within a fairly narrow band around its long‐term average. There are other periods when significant deviations occur. Some of these deviations reflect changing market perceptions about future inflation. For example, periods of significant decline in oil prices also tend to be periods when inflation expectations fall.

However, breakevens can drop for reasons that have little to do with inflationary expectations. Periods of financial stress often provoke strong demand for the safe and liquid assets. Nominal Treasuries are the asset class that investors seek out during such periods. This works to compress the spread between the yields between nominal Treasuries and TIPS. Sometimes, as during the height of the financial crisis in 2008, the compression in spreads will produce declines in breakevens that are not credible when compared with the inflationary history of the United States.

For TIPS investors the distortions to breakevens during periods of financial stress can be looked upon as opportunities. Historical experience suggests that a long‐term dip in inflation (as measured by the CPI) below 1% is quite unlikely, but this is what breakevens were priced for in late 2008. Moreover, TIPS investors need to consider that the Federal Reserve adopted an official inflation target of 2% in 2012.³ This target is defined in terms of the personal consumption expenditure (PCE) deflator, an alternative measure of consumer price inflation. In recent years, the CPI has run about 0.4% faster than the PCE deflator.⁴ Should the Federal Reserve achieve its inflation target of 2% for the PCE deflator, the CPI would likely rise slightly faster than that.

With the CPI having increased by an average of 2.4% per year in the past 25 years and the Federal Reserve having an inflation target that implies the continuation of a similar rate of increase, the fair value for 10‐year breakevens is probably within a range between 2.0% and 3.0%.⁵ Moves outside that range need to be analyzed carefully and often represent good trading opportunities.

In recent years, real yields have generally been very low and for some maturities negative. The Federal Reserve's real yields data for its 5‐year constant maturity series show negative real yields throughout the period from March 2011 to August 2014. This reflected very easy monetary policy as embodied by a near‐zero fed funds rate and forward guidance from the Federal Open Market Committee (FOMC) that the fed funds rate would be kept at that level for an extended period of time. The commitment to keep official rates near zero had the effect of pushing down both real and nominal yields for longer maturities. The FOMC's goal was to stimulate the economy by boosting those sectors such as housing that are sensitive to medium‐ and long‐term interest rates.

SEASONALITY OF CONSUMER PRICES

For TIPS issues close to maturity, investors need to carefully consider seasonal patterns. Table 12.1 shows the average change in the CPI by month over the 10‐year period ending in 2015.

As the data show, increases in the NSA CPI are much stronger in the first half of the year than the second. The NSA CPI often falls during the fourth quarter. This pattern is due in large part to seasonal movements in gasoline prices, which in turn reflect the maintenance patterns of refineries, which must comply with environmental regulations that call for cleaner‐burning and more expensive gasoline blends during the summer months. The seasonal pattern in the NSA CPI is often useful to investors trying to predict how much the principal of an issue will grow as it approaches maturity.

DIVERSIFICATION PROPERTIES

The risk‐return properties of inflation‐linked bonds and the correlation of those returns with the returns of other asset classes are important factors for investors to consider. A number of studies indicate that the returns on inflation‐linked bonds are weakly or negatively correlated with returns on other asset classes such as nominal bonds, equities, real estate, and commodities. A weak correlation with other asset classes implies that TIPS are a good source of diversification for a portfolio composed of those types of assets.

TAX TREATMENT

Interest payments on TIPS and increases in the value of the principal from inflation indexation are subject to federal tax but exempt from state and local taxes. The taxation of “phantom income” on accrued but not realized increases in the value of the principal on TIPS has been a negative feature from the perspective of investors. The Internal Revenue Service has a form that TIPS investors must fill out to calculate the amount of this income.

RISKS

While TIPS possess good diversification properties and help to protect investors against inflation, they are not without risk. As with any bond, their price fluctuates with interest rates. Moreover, in recent years the real yields implied by TIPS prices have at times been negative. While a drop in real yields implies a gain for an existing investor, very low or negative real yields are a potential source of discouragement for new investors.

There are also some event risks with respect to inflation that participants in the inflation‐linked bond market need to consider. These event risks are largely tied to government policy changes with respect to the structure of the tax system. The CPI measures consumer prices after sales taxes. If the United Stated shifts from the current largely income‐based system of taxation to one based upon consumption, this would result in a significant upward impact on consumer prices as the shift is implemented. Another potential policy change that would cause a potentially large rise in the CPI would be the adoption of a carbon tax, whether at the federal level or state and local level.

Technical changes to the consumer price index are also a source of risk that investors should consider. Over the past 20 years, the Bureau of Labor Statistics (the federal agency in charge of producing the CPI) has implemented a series of technical changes in order to improve the accuracy of the CPI as a measure of consumer price inflation. These changes have had the effect of slowing the growth rate of the CPI by slightly over 0.5% per year.⁶ Additional tweaks to the CPI remain under consideration.

ISSUANCE SCHEDULE

The Treasury Department issues TIPS through a series of auctions over the course of the year. In recent years, it has auctioned a new five‐year issue in April, with a reopening in August and December. Ten‐year TIPS have been auctioned in January and July, and auctioned as a reopening in March, May, September, and November. The 30‐year TIPS are auctioned in February and reopened in June and October. The auctions are conducted through primary dealers in a manner similar to auctions for nominal Treasuries.

I BONDS

The Treasury Department also sells I bonds, which are linked in a similar way to the CPI. Unlike TIPS, they cannot be sought and bought on a secondary market. The purchase limit for I bonds is $10,000 per Social Security number per year. Unlike TIPS, which use every month of CPI data to determine the growth rate of principal, I bonds only make use of the May and November CPI reports to determine accretion.

OTHER COUNTRIES

In 1981, the United Kingdom was the first major industrialized country to issue inflation‐linked bonds. Australia followed suit in 1985, and was joined by Canada in 1991, Sweden in 1994, France in 1998, Italy in 2003, Japan in 2004, and Germany in 2006. Several emerging‐market countries have also issued inflation‐linked bonds, including South Africa, Turkey, Brazil, and Mexico.

REASONS FOR ISSUING INFLATION‐LINKED BONDS

There are several reasons why countries choose to issue inflation‐linked bonds. Issuing inflation‐linked bonds provides diversification in debt instruments. There are potential savings if inflation is lower than anticipated. There are also indications that inflation‐linked bonds draw in certain investors that are less aggressive participants in the auctions for nominal Treasuries. Inflation‐linked bonds are an especially attractive asset class for defined‐benefit pension plans. Such plans can use TIPS to defease their liabilities.

The issuance of inflation‐linked bonds also provides central banks with a daily gauge of their credibility with the markets when it comes to controlling inflation. To the extent to which this helps central banks in conducting monetary policy, there may be macroeconomic benefits from having the information regarding inflationary expectations that is embedded in TIPS breakevens.

BOND MATHEMATICS

Concepts such as duration and convexity can be applied to inflation‐linked bonds. For inflation‐linked bonds, duration is a measure of sensitivity of price to changes in real yields. Compared to nominal bonds, coupon payments tend to be relatively small and principal repayment relatively large for inflation‐linked bonds. This implies that duration is higher for inflation‐linked bonds.

SUMMARY

Inflation‐linked bonds are an asset class with properties that are quite distinctive compared to other asset classes such as nominal bonds and equities. They tend to perform well relative to those other categories when inflation is rising. They appeal to investors seeking to control their risk exposure to inflation. Moreover, the returns on TIPS have a low correlation with other asset classes, including equities and conventional bonds. This implies that TIPS can improve the risk/return properties of portfolios that include those other types of assets.

The U.S. market has grown steadily since its inception in 1997, with the amount of TIPS held by the public now in excess of $1 trillion.⁷ In 2015, gross issuance of TIPS was $155 billion.⁸ In light of projections of substantial future federal deficits, it is likely that TIPS issuance will continue to be substantial.

In recent years, inflation has been low in most countries issuing inflation‐linked bonds. Breakevens have declined, partly because of a perception that inflationary risks have declined. This has provided investors with an opportunity to take out relatively cheap insurance against future inflation.