DEFINITION of 'Inflation-Indexed Security'

An inflation-indexed security is a security that guarantees a return higher than the rate of inflation if it is held to maturity. Inflation-indexed securities link their capital appreciation, or coupon payments, to inflation rates. Investors seeking safe returns with little to no risk will often hold inflation-indexed securities.

An inflation-indexed security is also known as an inflation-linked security or a real return security.

BREAKING DOWN 'Inflation-Indexed Security'

An inflation-indexed security has its principal indexed to the Consumer Price Index (CPI-U), or some other nationally recognized inflation index, on a daily basis. The CPI is the proxy for inflation that measures price changes in a basket of goods and services in the United States and it is published monthly by the Bureau of Labor Statistics (BLS). By linking a security to inflation, the principal and interest income received by investors are protected from the erosion of inflation. For instance, consider a bond that pays 3% when inflation is 2%. This bond will yield only 1% in real terms which is unfavorable for any investor living on a fixed income or pension.

An inflation-indexed security guarantees a real return. These real return securities usually come in the form of a bond or note, but may also come in other forms. Since these types of securities offer investors a very high level of safety, the coupons attached to such securities are typically lower than notes with a higher level of risk. There is always a risk-reward tradeoff for investors to balance. The periodic coupon on inflation-indexed securities is equal to the product of the daily inflation index and the nominal coupon rate. An increase in inflation expectations, real rates, or both, results in a rise in coupon payments.

The federal government offers several types of inflation-indexed investments, two of which are the Series I U.S. Savings Bond and the Treasury Inflation Protected Securities (TIPS). Let’s look at an example. A $1,000 TIPS is issued with 2.5% coupon rate to be paid semi-annually. The inflation rate is 3% compounded semi-annually and the bond matures in 5 years. The coupon rate per period is (2.5%/2) = 1.25%. The first semi-annual payment will be made on the principal value adjusted for inflation, which is $1,000 x (1 + 3%/2) = $1,015. The interest paid, therefore, is 1.25% x $1,015 = $12.69 after the first six months. Note that without accounting for inflation, the investor will receive 1.25% x $1,000 = $12.50.

At the time of maturity – in Year 5 or in Period 10 – the value of the principal adjusted for inflation will be:

= $1,000 x (1 + 3%/2)10

= $1,000 x 1.01510

= $1,160.54

The final coupon payment to be made in Period 10 will be:

= $1,160.54 x 1.25%

= $14.51

So, while the interest rate remains fixed at 2.5% per annum, the dollar value of each interest payment will rise, as the coupon will be paid on the inflation-adjusted principal value. However, in the case of the Series I Savings bond, the interest rate on the bond changes because it is adjusted according to daily inflation. If inflation increases, the interest rate on the savings bond will be adjusted upwards. During periods of deflation, the bonds are guaranteed to never drop below 0.00%.

Inflation-indexed securities provide a low-risk investment vehicle in which the return is guaranteed not to fall below the rate of inflation. Except for TIPS bonds, the market for these securities is comprised mainly of buy-and-hold investors. As a result, the market for inflation-indexed securities is fairly illiquid.

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