Inflation-linked bonds are a way to protect your investment's principal amount from being eroded by the forces of inflation. Inflation refers to the general rise in prices of goods and services in an economy over time, and so can also be construed as a reduction in the purchasing power of one dollar. Therefore, $100 today may only be "worth" $95 in a year's time - indicating a 5% annual rate of inflation. Therefore, an investment returning 4% in a year would actually be a net loser after inflation has been taken into account.
Luckily, there are several inflation-linked securities now available to investors that keep up with the rate of inflation at a minimum, such as CDs and bonds. Standard yield calculation methods still apply to inflation-adjusted bonds, only investors are more likely to pay attention to real yield with an inflation-adjusted bond moreso than the nominal rate. Indeed, inflation-adjusted bonds have yields that appear to be lower than non-adjusted (nominal) bonds - but, this is because the bond yields for inflation-adjusted bonds are specified as a percentage rate in excess of measured inflation.
- Inflation-linked securities protect an investor's principal from a loss of purchasing power due to inflation.
- U.S. Treasury TIPS are among the most popular inflation-adjusted bonds, but municipal bonds, CDs, insurance policies, and other assets may also be adjusted for inflation or linked to CPI.
- Calculating the yield on an inflation-linked bond is quite similar to any other bond, except the real yield and not the nominal yield is used.
How to Calculate the Yield of a Bond
To find the real (rather than nominal) yield of any bond, calculate the annual growth and subtract the rate of inflation. This is easier for inflation-adjusted bonds than it is for non-adjusted bonds, which are only quoted in nominal changes.
Consider the difference between a regular U.S. Treasury bond (T-bond) and a Treasury inflation-protected security (TIPS). A standard T-bond with a par value of $1,000 and a coupon rate of 7% will always return $70.
A TIPS, on the other hand, adjusts its par value according to inflation. If inflation is 5% during the course of a year, a $1,000 par value TIPS would turn into a $1,050 par value even if the secondary market price of the TIPS declined over the same time.
Example: TIPS Calculation
A $1,000 par value TIPS with a 4% coupon would initially generate a return of $40. If inflation-adjusted the par value to $1,050, the coupon payment would instead be
$42 = ($40 x 1.05).
Suppose the TIPS were trading at $925 on the secondary market. The real yield calculation would use the secondary market price (like any other bond) of $925, but use the inflation-adjusted coupon payment of $42. The real yield would thus be:
4.54% (42 ÷ 925).
Bonds Linked to the CPI
Bonds that are linked to the consumer price index (CPI), for example, generate yields that have an embedded inflation assumption. If nominal government bonds are yielding 5% and TIPS are yielding 3% for the same maturity, the assumption is that the annualized CPI will be 2%. If actual inflation over the course of the year exceeds 2%, the TIPS bondholders receive a higher real return than nominal bondholders. That 2% threshold is referred to as the inflation break-even point, beyond which the TIPS becomes a better value than the nominal bond.