Municipal Inflation-Linked Securities

What Are Municipal Inflation-Linked Securities?

Municipal inflation-linked securities are investment vehicles, issued by local municipalities, where the variable coupon payments is indexed to the inflation rate, as measured by the Consumer Price Index (CPI).

Understanding Municipal Inflation-Linked Securities

Municipal inflation-linked securities are securities similar to municipal bonds which are sold to investors. They are purchased with a principal investment and they pay a steady coupon rate, or interest rate, on that principal. They have a specific maturity date, and are used to raise money for some sort of municipal improvement or infrastructure project.

Municipal inflation-linked securities vary the assumed amount of principal by tying it to the Consumer Price Index (CPI), an accepted measure of the actual inflation rate. By varying the assumed principal along with the CPI, the security protects the holder from inflation risk. They also do not increase in price if the rate of inflation decreases. Because fewer investors purchase municipal inflation-linked securities than municipal bonds, they can be hard to trade, so they are not considered particularly liquid.

Municipal Inflation-Linked Securities vs. Municipal Bonds

Municipal inflation-linked securities are very similar in most ways to municipal bonds. They are both issued by municipalities to raise money for infrastructure projects, such as roads, parks, schools and airports. They are both structured the same way, with a principal amount that the investor pays, and a coupon rate that the municipality pays the holder in interest for holding the security.

The big difference between the two is that a municipal bond pays one coupon rate for the duration of the bond until maturity, while a municipal inflation-linked security adjusts the assumed principal to keep track with inflation. By adjusting the principal for inflation, when the coupon rate is calculated, that payment is adjusted for inflation, too. This keeps the rate of a municipal inflation-linked security paying out above the rate of inflation.

During periods of inflation, if the inflation rate was greater than the coupon rate, it would be possible to lose money by investing in a municipal bond, because the interest earned on the bond would be less than the value the money was losing through inflation. By tying it to the CPI and adjusting the amount of principal to the inflation rate, the coupon rate is accrued on top of inflation. This is how municipal inflation-linked securities can protect investors from losing money during periods of inflation. This is also why municipal inflation-linked securities offer lower coupon rates than do comparable municipal bonds.