How are TIPS bonds calculated

Negative real returns on US Treasury inflation-linked bonds (TIPS)

(Excerpt from pages 6-7 of the BIS Quarterly Review, December 2010)

On October 25, 2010, the US Treasury Department first issued Treasury Inflation-Protected Securities (TIPS)1 with a negative real return. TIPS are Treasury bonds that have a coupon payment on an amount of principal that is indexed to US consumer prices. The principal paid out on maturity of the bond compensates investors for increases in the CPI since the bond was issued. At the most recent auction, investors purchased 4½-year TIPS for a total of $ 10 billion, paying $ 105.51 for a face value of $ 100.00 and a coupon of 0.50%. This pricing resulted in an annual real return of -0.55% on hold to maturity, i.e. investors expected to lose more than ½% on their investment in real terms every year.2 Why did you enter into this business?

The high prices that were paid at the auction corresponded to the current price level on the TIPS market, where real yields - especially on short and medium-term Treasury bonds - had already fallen well below zero (Graph A, left). Real yields had already declined in line with nominal yields for much of 2010, but the decline accelerated after Federal Reserve Chairman Bernanke's speech in Jackson Hole on August 27. Investors took this as a signal that the Federal Reserve was planning further Treasury bond purchases. In the following two months, real yields collapsed more than nominal ones, so that 5-year real yields finally fell below zero.

The falling real yields primarily reflected increasing inflation compensation (expected inflation and inflation risk premium) by investors in September and October (Graph A, center), in line with increasing expectations of monetary easing in the US. Since the expectation that the Federal Reserve would undertake new bond purchases was noticeably depressing nominal yields, the higher inflation expectations and inflation risk premiums had to be taken into account by a further drop in real yields.3

There is little evidence that the rise in breakeven inflation rates was related to factors specific to the bond market (such as considerations related to the liquidity of bonds). The inflation swap rates rose in September and October largely parallel to the breakeven rates on the bond market.4 These two breakeven metrics would likely have moved less synchronously if the increase had instead been due to a change in investor perception of the relative liquidity of the nominal and indexed bond markets. The same is true of the possibility that the government bond breakeven rate may have been "skewed" by expectations that the Federal Reserve would intervene in the bond markets.

The negative real returns were also in line with the pricing of nominal bonds. This is how a rough indicator of the expected Real yield on 5-year nominal US Treasury bonds - which is calculated from the nominal yield minus the 5-year inflation swap rate - essentially parallel to the real TIPS yield and was also clearly negative on the day of the auction mentioned above (chart A right).5 This also indicates that the price level of the TIPS was not "unusual" at that time.

The negative real returns also reflected expectations of market participants that future short-term real returns would remain negative for some time. According to the expectation hypothesis of the interest rate structure, the yield on a US Treasury bond reflects the average short-term interest rate over the term of the bond plus a term premium. This applies to both nominal and real bond yields. As the Federal Reserve continues to signal its intention to keep the nominal overnight target rate near zero for a long time, real short-term interest rates will remain negative as long as inflation rates are positive. Without taking the term premiums into account, the TIPS returns are therefore likely to be negative over term horizons in which, on average, negative short-term real returns are expected.

Another factor that increases the price level of TIPS and thus dampens real returns is the fact that these bonds have option-like characteristics, which are of great value in times of high uncertainty about future inflation developments. First, in contrast to nominal bonds, TIPS offer investors protection against unexpected developments in inflation. In addition, this inflation protection is designed asymmetrically. Investors are compensated for higher inflation by indexing the principal to the CPI, but in the event of deflation, the principal is not reduced.6 Thus, in the event of deflation, TIPS investors benefit just as much as holders of nominal bonds, but have the additional advantage of hedging against rising inflation.7 In other words, TIPS have a built-in inflation option with zero inflation as the exercise price. Like all options, this is particularly valuable when it is "at the money" (ie close to the exercise price) and when there is high uncertainty (volatility) in the market. This is currently the case in the USA, which further increases the value of TIPS and theirs This also dampens returns.8 As a result, investors have accepted negative real returns in order to protect their capital against inflation while preserving the option to benefit from possible deflation.

1 These instruments are sometimes referred to as Treasury Inflation-Indexed Securities (TIIS).
2 Unless the US CPI falls during the life of the bond (see below).
3 Investors widely believed that the Federal Reserve's purchases would be almost entirely of nominal Treasury bonds.
4 In the case of (zero-coupon) inflation swaps, a payment in the amount of the CPI increase, which accrues to the nominal amount of the swap over its term, is made against a predetermined price.
5 On October 25, the date of the TIPS auction, the 5-year nominal yield was 1.18%, while the 5-year inflation swap rate (a rough indicator of expected inflation over the next five years) was 1.91% so that an expected real return of around -0.73% resulted for the nominal bond.
6 This results from the structure of the bond conditions. The Treasury Department pays either the nominal amount or the principal amount adjusted for inflation, whichever is greater, when due.
7 In the event of deflation during the term of the bonds, TIPS investors have the slight disadvantage compared to holders of nominal bonds that the deflation floor relates only to the principal amount and not to the coupon payments. TIPS coupons are based on the inflation-adjusted principal, even if inflation is negative.
8 This option is particularly valuable for newly issued TIPS that have not yet accumulated much inflation and therefore have a principal close to face value. As a result, the yields on such bonds tend to be lower than those of older bonds with a similar remaining term.