INFLATION-PROTECTED SECURITIES

Introduction
Fixed-income investments pay a specified amount of interest at regular intervals until
maturity when the original principal is also returned. There are many risks that fixed-income
investors face such as interest rate, where the asset prices can fluctuate in value given a
change in the interest rate; credit risk, more specifically for non-governmental issues where
the issuer is unable to make interest and/or principal payments; liquidity risk, due to the lack
of trades in the market of that particular security, etc.
One other particular threat to fixed-income investors is the risk of inflation. Inflation is
defined as the increase in the price of goods and services and subsequently, a fall in
purchasing power. There are some predominant accepted measures of inflation used in
different countries; the Consumer Price Index (CPI), the Retail Price Index (RPI), the
Harmonised Index of Consumer Prices (HICP), the Producer Price Index (PPI). These indices
notionally cover a basket of certain goods and services bought by households (see figure 1).
They are weighted to their average share of a household expenditure. The items in the basket
are reviewed every year to reflect the change in the market and consumer spending patterns.

Figure 1: Components of Inflation Indices; source from Deutsche Bank

Investors of standard fixed-income securities bear inflation risk in that the purchasing power
of interest payments could be eroded over and above their original expectations throughout
the life of the bond. This could be particularly damaging for very long maturity securities.
Suppose you purchase a one year zero-coupon bond today for $90, par value of $100. The
return is a $10 capital gain; hence the real interest rate can be calculated as 11.1% ($10/$90).

Factoring in an inflation rate, say 2%, the real interest return would only be 8.9%
[(1+11.1%/1+2%)-1].
Real Rate of Return= [(1+r)/(1+i)] -1
Where, r: nominal rate of return and i: inflation rate
This can be approximately stated as:
Real Rate of Return Nominal Rate of Return Inflation Rate
Figure 2 shows how the effect of inflation, using RPI, has destroyed over 40% of the
purchasing power of the British sterling over the last 20 years.

Figure 2: Data from the Office of National Statistics, base of 100 in 1991

Emergence of Inflation-Protected Securities

The introduction and emergence of inflation-protected securities (IPS) have become
important to both economists and investors. For many, IPS are guaranteed to keep pace with
inflation and effectively to provide a real rate of return. For economists, it has provided a tool
to estimate the rate of inflation.
The development of IPS has expanded around the globe in more recent years. Barclays
Capital data state that as of 2013, the global market value of IPS was approximately $2.0
trillion ($866 billion in the US and 338 billion in the UK). The UK is generally accepted as
one of the first issuer of IPS in 1981 with the Index Linked Gilts (IL-Gilts) The US followed
much later with the issuance of Treasury Inflation Protected Securities (TIPS) in 1997.

Figure 3: Data from Office of National Statistics

Much of the 70s saw the economies of developed countries in stagflation, illustrated in figure
3, which would have had a devastating effect on investment. The stagnant growth, high
unemployment rate accompanied with high inflation, was due to the dramatically sharp rise in
world oil prices. An aggressive monetary and fiscal tightening had been implemented to bring
inflation under control in the UK. IL-Gilts, issued and priced by UK Debt Management
Office were developed to save the government money, especially when inflation fell sharply
and stayed low (this ultimately brought inflation expectation down too).
With an aging population, savers and pension funds, who deferred consumption, was
concerned in the future real worth of savings. Funds of this nature have long-term liabilities,
often linked to inflation or earnings and thus have a strong appetite for inflation-linked assets
to put on the other side of the balance sheet. This demand was another reason for the creation
of IL-Gilts.
It was announced in the 1996 press conference made by Robert Rubin, the US Treasury
Secretary, that TIPS were developed as an attempt to broaden the investor base for US
government debt and to lower the cost of funding. Conventional bonds exposed investors to
inflation risk, so their yields presumably contain an inflation risk premium; by issuing TIPS,
the Treasury could avoid paying the premium.

General Structure
TIPS and IL-Gilts are offered at a minimum purchase price of $1000/ 1000 with a fixed
semi-annual coupon rate. TIPS issued quoted price is the real price and is specifically
indexed to Consumer Price All Urban Non-Seasonally Adjusted Index (CPI-U) in United
Stated. IL-Gilts are traded in the clean price are indexed to the Retail Price Index (RPI).
These two indexes have an issue metric of 100 and change when inflation goes up or down
(the RPI was re-based in January 1987 from 394.5 to 100). RPI usually shows a higher rate of
inflation than CPI as it includes mortgage interest payments, house depreciation, council tax,
TV licences etc.

The chart below summarises the main difference between US and UK IPS:
US
Linked to CPI-U

Treasury Inflation
Protected Securities (TIPS)

Time lag is 3 months

UK
Linked to RPI

Index Linked Gilts (ILGilts)

Time lag is 3/8 months
depending on issue date.
(3 months for securitues
issued after 2004)

Deflation floor
No deflation floor

The representation of an IPS would be as follows:

US TIPS
Adopting the Canadian Model, US TIPS trade in real space with reference to an index. A
daily reference index is calculated with the index 3-month previously, for example, the index
level for 01 October 1996 would be used for 01 January 1997 issue. The reference indices for
intervening days are calculated as follows:
Index = CPIm-3 + [(t-1)/ D] x (CPIm-2 CPIm-3 )
Where m= settlement month, D= number of days in month m, t= day of the settlement
month
For example, to calculate the CPI-U at a specific date, 07 January 1997, we take the CPI-U
for 01 January 1997, 158.3, and the CPI-U 01 February 1997, 158.6. Taking the difference of
0.3 (158.6158.3), we divide this with the number of days in the month, 31, to give us
0.0096774. Finally, we would have to multiply the result with 6, because we are calculating
the index level for 07 January, 0.05806 (0.0096774 x 6). This result is added to the index
level of 01 January to give us 158.35806.
The changes in the CPI-U during the lifetime of TIPS are incorporated into an index ratio.
Index Ratio = Reference CPIt / Reference CPIbase
This ratio is applied to adjust the principal for any rise in inflation
Principal = Face Value x Index Ratio

The semi-annual coupon payment is likewise adjusted by the factor (equivalently, it is

calculated on the inflation-adjusted principal)
Coupon Payment = 1/2 x Coupon Rate x Index Ratio

Index Ratio
Semi Annual Coupon Rate
Principal balance

218.7644 / 184.7742
(1/2)x2%x1.183955
1.183955x100

1.18%x100
Coupon
Or
1%x118.396
Coupon
Figure 4: Index ratio calculation example

1.183955
1.18%
$118.396
118
118

To explain figure 4, on 15 January 2004, the US Treasury issued 10-year TIPS, 2% coupon,
15 January 2014 maturity. The reference CPI-U was 184.7742 at the issuance date of the 10year bond. Six years on, 18 January 2011, the reference CPI-U was 218.7644. The index ratio
was therefore 1.18396. The semi-annual coupon payment was 1.18396% and the principal
balance was $118.396 for every $100 of notional purchased at issue.
At maturity, investors of TIPS receive the greater of the inflation-adjusted principal or the par
value. This is known as floor:
Principal at Maturity = Notional x Max [(Lb/La-1)-K, 0]
Where K= pre-agreed inflation threshold and a to b= interval over which inflation is
measured
As the price of TIPS is made by multiplying the stated value at issuance with the index ratio,
the nominal prices are defined as the real prices plus the lagged actual inflation rates. In some
cases there is also a premium for the liquidity risk.
The securities are indexed to inflation by adjusting the principal outstanding per unit of the
par value. The coupon rate is fixed but the semi-annual coupon payments are determined by
multiplying the coupon rate with the inflation adjusted principal.
Time
(Period)

Standard Inflation
Coupon

Principal
($)

1
2
3
4
5

2.25%
2.25%
2.25%
2.25%
2.25%

1000
1020
1050.6
1092.624
1081.69776

0%
2%
3%
4%
-1%

Principal
Adjustment
($)
0
20
30.6
42.024
-10.92624

Standard
Portion
($)
22.5
22.5
22.5
22.5
22.5

Inflation
Portion ($)
0
0.45
0.6885
0.82754
-0.2342754

Total
Payment
($)
22.5
22.95
23.1885
23.42754
22.2657246

Figure 5: Table to show the adjustment of a 5-year TIP, coupon rate 2.25%
Figure 5 illustrates the breakdown the standard portion with the inflation portion. With the
observed fixed standard portion (reflective of the coupon rate), we can see how the total
payment changes accordingly with the effect of inflation through the inflation portion.

Cash Flow ($)

160
140
120
100
80
60
40
20
0

Principal Uplift
Unadjusted Principal
Coupon Indexation
Real Coupon
1

Year (Period)

Figure 6: Illustration of potential cash flow

Figure 6 is a visual illustration of the potential in cash flow. The prominence of principal
repayment relative to interim cash flows as a result of the adjustment to reflect the inflation
rate is obvious. IPS has higher duration than conventional bonds, assuming that inflation is
non-negative.
TIPS have also become strippable instruments (iStrips) into the various coupon components
and singular principal component. The greater of par value or inflation-adjusted principal
would be received with the principal strip. For the stripped interest component, an adjusted
valuation (AV) is used:
AV = [(C/2) x Par Value] x (100/CPIbase)
And the amount payable (AP) at maturity is then calculated:
AP = AV x (CPI reference value at maturity/100)

UK IL-Gilts
Instead of trading in real space, UK IL-Gilts trade in nominal space so the inflation value of
the next coupon is needed to allow for accrued interest to be calculated. The indexation is
therefore completed with an 8-month lag. This means that the principal value of the IL-Gilt
July 2008 issued in July 1983 will be uplifted by the percentage increase in the RPI between
November 1982 and November 2007.
The semi-annual coupons are calculated as follows:
Coupon Paid = (C/2) x (RPIm-8 / RPIi-8)
Where m = payment month and i = issue month
Accrued interest is calculated on the money value and not the real value of the coupon. As
mentioned, unlike TIPS, there is no floor in the event of deflation, so at redemption, similarly
to the coupon, the cash value is calculated as:
Redemption Value = 100(RPIm-8 / RPIi-8)

Inflation Expectation
An understanding of market inflation expectations is of use to economists and policy makers
and the determined yield against the inflation target gives an indication of how credible to
target is itself.
For TIPS, the breakeven inflation (BEI) is the difference between the yield on TIPS and a
comparable T-bond of the same maturity.
Breakeven Inflation = Treasury Bond Yield TIPS Yield
The BEI is further broken down into inflation expectation and a risk premium. Theoretically,
if investors believe inflation is higher than the current BEI, TIPS should be bought as they are
under-priced and vice versa. In case the metric exceed the actual inflation, conventional
bonds prices decrease whereas TIPS prices increase, because the risk premium that is paid for
was unneeded. However, when actual inflation is close to the predicted the returns of normal
and inflation protected bonds are closely correlated and we have minor fluctuations in their
prices.
For IL-Gilts, the Fisher Identity model is used. The inflation expectation is the spread
between the real yield on the IL-Gilt and the yield of a conventional gilt of the same maturity.
As IL-Gilts are traded with nominal prices, to derive the real yield metrics, we would need to
know the cash flows that are owned, which is uncertain. To overcome this problem, an
assumption is made termed money yield: assumes that RPI grows at a rate beyond the last
known value, currently 3% annually.
RPIt = RPIt-1 (1+f)1/12
Where f = money yield
The coupon payments and redemption value are mapped accordingly to their RPI assumption
From here the yield/ IRR can be estimated. Figure 7 illustrates this relationship.

Figure 7: Visual illustration of the yield curves

In reality, inflation predictions include a significant difficulty so as to be accurate, and for
that reason governments future inflation expectations are highly dependable to the current
period inflation.

Correlation & Diversification

IPSs have been used as a risk diversification tool for portfolios due to their low correlation
with other asset classes. Figure 8 below illustrates the correlation between TIPS and other
asset classes.

Figure 8: Historical correlation between traditional inflation-hedging asset classes & TIPS
Although TIPS are directly linked with inflation, the correlation is low due to changes in
interest rate and other factors. It is also evident that using a shorter duration TIPS index, the
correlation between TIPS and inflation can be minimized; from 0.08 to 0.18. TIPS also have
relatively lower correlations with other asset classes. This makes TIPS (and generally other
IPS) an effective diversification tool; mitigating risk and improving returns. Factors that may
affect the demand for TIPS include inflation expectations, risk appetites, absolute real yield
levels, supply and expectation of higher CPI.

Figure 9: Efficient frontiers showing effects of diversification

Over the long term, IPS have approximately the same returns as conventional bonds with
lower volatility, thus IPS can be, to a certain extent, superior. Some analyses propose that
conventional bonds should be completely replaced by IPS with respect to asset allocation, as
the combination of stocks, other real assets, and IPS could be optimal from a risk standpoint.
Figure 9 shows that for the same level of standard deviation, the portfolio offers higher
returns with IPS (assuming everything else constant). Another way to view this is that for the
same return, the portfolio has lower standard deviation with a combination of IPS and equity
than with conventional bonds and equity.

Benefits & Challenges

There are distinguishing advantages and disadvantages of IPS. We can observe that in general
IPS are considered as a safer investment decision compare to conventional bonds, being
independent of inflation, a significantly unpredictable risk. Figure 10 compares payments
schedules and values.
Payment under
conventional bond

Payment under IPS with different inflation

scenarios
= 0%
= 4%
5.5%
3.5%
Coupon Rate
55
35
36.4
Y-1
(Adjusted Principal)
1000
1040
55
35
37.86
Y-2
(Adjusted Principal)
1000
1081.6
55
35
39.37
Y-3
(Adjusted Principal)
1000
1124.86
55
35
40.95
Y-4
(Adjusted Principal)
1000
1169.86
55
35
42.58
Y-5
(Principal)
1000
1000
1216.65
Figure 10: Comparing a conventional bond with in IPS
The payments of the hypothetical 5-year IPS and conventional bond assume annual interest
payment. The dollar payments of IPS are adjusted in two different (but constant) inflation
scenarios, 0% and 4% and we can see how with a lower coupon and inflation, the IPS pays
out more. Figure 11 summarises the difference between the two.
Conventional Bond

Inflation-Protected Security

Real yield varies inversely with inflation

y(real) = y(nominal) -

Real yield remains constant with inflation

Par value of principal obtained at maturity

Real value of the principal obtained at

maturity

Figure 11: Summary of conventional bond versus IPS

Risk neutral investors would prefer this investment opportunity, or risk taking investors
would choose it as a diversification strategy for hedging against inflation. Governments can
also avoid paying the risk premium with the issuance of IPS, raising cheaper capital. The risk
premium is paid to conventional bond investors because of the potential risk in inflation.
The issuance of IPS could create positive government credibility and reduce sovereign risk.
Issuing IPS can be perceived as actively trying to bring down inflation and offering options
such as deflation floors shows the governments obligation to protect investors.
On the other hand, IPS are often criticised for being hard to calculate; mathematically they
are harder to quantify but conceptually there are less uncertainty as a product. IPS are less
liquid than conventional bonds as investors would look to hold them to the end of maturity,
reaping the benefits of real rate of returns. In addition, some IPS have only been recently
introduced, with short supply; its limited existence makes them less liquid as well as
competition against other traditional assets to hedge against inflation such as gold and
commodities.
Taxation on TIPS poses an issue as the appreciation in principal amount in the year it occurs.
This produces a phantom income that is subject to taxation. If high enough, investors may
experience negative cash flows. The lag between the inflation announcement and its impact is
another factor that could affect the returns and prices. In a stable inflationary economy, a 3 or
8-month lag would not sufficiently affect the return or price. However, given volatile
inflation rates, the lag can cause substantial changes, resulting in very inconsistent income.
Lastly, in the case of TIPS mutual funds, deflationary periods can lead to low or no
dividends, offering no protection, because the negative adjustments on income are measured
as negative income. Figure 12 summarises the benefits and challenges.

Figure 12: Summary of the benefits and challenges of IPS

Expected performance of IPS against conventional bonds is more obvious in
economic/inflation environments as depicted in figure 13. If the outlook for inflation is
up/down, an investor should prefer/not prefer investment in IPS. With the other scenarios,

growth/inflation and recession/disinflation, the expected return of indexed IPS against a

conventional bond is not as obvious. Typically, these are periods when the investor must look
to current and expected monetary policy to drive the decision.

Figure 13: Matrix illustrating when to buy IPS

Japan JGBi

Figure 14: Japans inflation rate from 2004 to 2013

On March 2004, the Japanese government introduced the 10-year JGBi, an inflation-linked
bond whose principal fluctuated proportionately with the countrys CPI, excluding fresh food
as this was volatile. As inflation rates in Japan were low and more often negative (figure 14),
the issuance of the JGBi were to meet the needs of investors who wanted to avoid inflation
risk and as a way to observe inflation rate, although it would take a couple of years before the
implied inflation would be a reliable enough gauge. Deflation floor protection was absent in
these issues because pricing this option, in a country where prices had been drifting
downwards, would have been a major component of its overall value. As the calculations for
real yields and breakeven values do not adjust for the option, these values would have been
relatively hard to interpret.
The JGBi represents a very small portion of the Japanese government bond market, where
years of persistent deflation have increased demand for low nominal yields on offer from
regular, fixed rate bonds. Japans Ministry of Finance suspended the issuance of JGBi in

2008 due to the financial crisis and fears of deflation. Following a period of growth, they
were reissued in October 2013, this time incorporating a deflation floor. In case where the
indexation coefficient falls below 1 at maturity, the principal amount will be redeemed.
Following graphs illustrates the volatility of inflation for Japan.

Average inflation rate: -0.01% (2004)

Average inflation: -0.27% (2005)

Average inflation: 0.24% (2006)

Between 2007 and 2012, the average inflation rates each year were as follows: 0.06%, 1.37%,
-1.34% , -0.72% , -0.28% and -0.03% in 2012.

Germany Bobl ei / Bund ei

Figure 15: Germanys inflation rate from 2006 to 2013

One criticism of IPS is that they do more harm than good; issuing IPS means an increased
pressure for other assets to be linked to inflation also which was why before 2003, it was
illegal for any debt to be indexed in Germany.
There are currently four inflation-linked German bonds as shown in figure 16 and they were
first issued in 2006; the Currency Act of June 1948 generally prohibited the indexing of
contracts until its abolition in 1998. These instruments accounts for 4% of Federal
Governments Debt portfolio and the government also conducts secondary market operations
to support the liquidity for these securities. They are annually indexed to the European HVPI
which excludes tobacco and the redemption is at least par value.

Figure 16: Outline of current German IPS as of Oct 2013

Their entrance into this market was due to a long-term expectation of a reduction in interest
costs. It was also aimed at broadening the investor base, increasing financing flexibility and
extending volume of securities offered to investors. The government is continuing to issue
IPS with a total volume of 8 to 12 billion in the primary market. Liquidity in inflationlinked instruments has risen continuously and in 2012 and trading volumes sits at 180
billion.
As the nominal value is adjusted to the index, the real coupon is always paid on basis of this.
In the case of deflation coefficient could go below 1, therefore the nominal could below 100
during the life of the bond. This implies that coupon payment could also be below the coupon
related to original nominal value.
Nevertheless, the coupon of German government bond cannot go below zero. The coupon is
always fixed and defined in the terms of the individual securities. However interest payment
can vary based on the fact that the coupon is paid on inflation indexed capital. To be more
precise, value of the underlying basket of goods where the inflation index is calculated from,
which always has to be >0, hence the indexation coefficient and interest payment cannot be
below 0 or negative.

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