Treasury Inflation-Protected Securities (TIPS)
U.S. Treasury securities pay a fixed coupon rate periodically and mature at par. While these securities
carry no risk of default, they still expose investors to the possibility that the inflation rate will outpace
the coupon interest rate, and thus the real return will be negative. In order to protect against this
inflation risk, a Treasury Inflation-Protected Security (TIPS) were issued in 1997.
Treasury Inflation-Protected Securities are negotiable bonds issued and guaranteed by the U.S. Treasury
with returns that are indexed to compensate bondholders for actual inflation. Treasury Inflation-
Protected Securities are securities whose principal is adjusted by changes in the Consumer Price Index as
measured by the Bureau of Labor Statistics Consumer Price Index for All Urban Consumers (CPI-U): U. S.
City Average, by expenditure category and commodity and service group (not seasonally adjusted).
With inflation (a rise in the CPI index), the principal increases. With a deflation (a drop in the CPI index),
the principal decreases. Thus, while the coupon rate does not increase, the dollar amount of interest
paid to the bondholder does.
The relationship between TIPS and the Consumer Price Index affects both the maturity amount that
bondholders are paid when TIPS mature and the amount of interest that a TIPS pays (TIPS pay interest
semi-annually). While TIPS pay interest at a fixed coupon rate, because the coupon rate is applied to an
inflation adjusted principal, interest payments can vary in amount from one period to the next. Twice a
year the fixed coupon interest rate is multiplied by the new inflation adjusted principal. Semiannual
interest payments are based on the inflation-adjusted principal at the time the interest is paid. If
inflation occurs, the interest payment increases. In the event of deflation, the interest payment
At maturity, TIPs repay the inflation-adjusted principal or original par value, whichever is greater.
The market for TIPS has grown steadily and now includes three terms to maturity: 5 years, 10 years, and
20 years. The Treasury auctions 5-year and 20-year TIPS semiannually and 10-year TIPS quarterly. The
trading volume of TIPS also has increased gradually but still remains small compared to other Treasury
securities; hence, TIPS generally are not as liquid as comparable Treasuries.
A TIPS Example
Suppose an individual invests $1,000 on January 15 in a new inflation-protected 10-year note with a 3%
real rate of return.
If inflation was 1% during the first six months of that year, then by mid-year the inflation-adjusted
principal amount of the security would be $1,010 ($1,000 x 1.01 = $1,010).
In addition, at mid-year, on July 15, the investor would receive the first semiannual interest payment of
$15.15 ($1,010 times 3% divided by 2).
Suppose, then, that inflation accelerated during the second half of the year, reaching 3%.
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By the second semiannual interest payment date, January 15, the inflation-adjusted principal amount of
the security would be $1,030. ($1,000 x 1.03 = $1,030).
The second semiannual interest payment would be $15.45 ($1,030 times 3% divided by 2).
TIPS and Inflationary Expectations
It is assumed that the difference between the yield offered by a regular Treasury and TIPS having the
same maturity is an indication of the inflation expectations, also called the breakeven rate. At a basic
level, the yield-to-maturity on a regular Treasury bond that pays its holder a fixed nominal coupon and
principal must compensate the investor for future inflation. Thus, this nominal yield includes two
components: the real rate of interest and the inflation compensation over the maturity horizon of the
bond. For TIPS, the coupons and principal rise and fall with the CPI, so the yield includes only the real
rate of interest. Therefore, the difference, roughly speaking, between the two yields reflects the
inflation compensation, or the market’s expectation of future inflation, over that maturity horizon.
Extracting Inflation Expectations from Treasury and TIPS Yield Curves
What level of inflation do market participants expect over the next 5, 10, or even 30 years? One
relatively straightforward method is to examine the “breakeven” inflation rate which is the difference
in interest rates between Treasuries and TIPS of similar maturities. This method has the advantage of
being determined by market prices, so it reflects the views of investors who have money on the line.
An example illustrating the 5-year breakeven inflation rate from January 1, 2010 to the present is shown
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The 5-year breakeven inflation rate is the difference between the 5-Year Treasury Constant Maturity
Rate (in this case the most recent rate is approximately 2.25%) and the yield on an inflation protected
security with 5-years remaining to maturity is close to 0%. Therefore, the plot implies investors expect
inflation of approximately 2.25% annually over the next 5 years. It can also be seen from the graph that
the breakeven inflation rate has been rising over recent months as the gap between the two series has
widened. This is shown in the following illustration which plots the difference between the 5 year
Treasury rate and the 5-year TIPS rate.
Why should we expect that the difference in yields is equal to the market’s expectation for inflation? If
investors expected future inflation to be greater than this difference, then this would make TIPS, whose
coupon and principal payments are indexed to the CPI, more attractive to investors than nominal
Treasuries and the difference would increase as investors sold Treasuries (pushing down the price down
and yield up) to buy TIPS (pushing the price up and yield down). If inflation expectations were lower
than this difference, then Treasuries would be more attractive to investors than TIPs and the opposite
effect would occur. Therefore, in equilibrium, the difference should roughly reflect the market’s
consensus for future inflation.
Treasury Inflation Bets Rise to Most Since 2008 Following Oil Price Surge
Bloomberg.com, March 8, 2011
Treasury traders increased bets inflation will accelerate to the highest level since July 2008 as oil traded
at almost a 29-month high.
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The yield difference between 10-year notes and Treasury Inflation Protected Securities, a gauge of
trader expectations for consumer prices over the life of the securities, widened to as much as 2.55
percentage points, the most in 32 months (see chart below for 10-year breakeven inflation rate from
January 2005 to the present). The extra yield investors demand to hold 30-year bonds over two-year
notes increased for a third day to 393 basis points.
“Investors are increasingly nervous that higher oil prices will push up headline inflation,” said Nick
Stamenkovic, a fixed-income strategist in Edinburgh at RIA Capital Markets Ltd., a broker for banks and
investors. “The longer end is being influenced by the perceptions on inflation and creeping concerns
that the Federal Reserve is getting a bit behind the curve compared to other central banks.”
The prices of oil products have surged amid unrest in Libya. Gasoline advanced 11 percent on the New
York Mercantile Exchange last week. Crude for April delivery rose to $106.95 a barrel yesterday in New
York, the highest level since September 2008, as Libyan warplanes bombed rebel positions near the
crude- producing hub of Ras Lanuf.
“We have to watch, and we are watching very carefully, how much pass-through and how much pricing
power there is and how much can be passed through to the consumer and how damaging it can be,”
Federal Reserve Bank of Dallas President Richard Fisher said yesterday in Washington.
10-Year Breakeven Inflation Rate
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