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Published by Bindia Ahuja
Benefits and limitations of inflations indexed treasury bonds
Benefits and limitations of inflations indexed treasury bonds

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Published by: Bindia Ahuja on Apr 09, 2013
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Benefits and Limitations of InflationIndexed Treasury Bonds
 By Pu Shen
n recent years, members of Congress and aca-demia have repeatedly urged the U.S. Treasuryto issue some portion of its debt in the form of inflation indexed bonds. With an indexed bond, theinterest and maturity value are adjusted by the rateof inflation over the life of the bond. Because thecash flow of an indexed bond is adjusted for infla-tion, the bond’s real value does not vary with infla-tion, protecting investors and issuers alike frominflation risk.Inflation indexed bonds would be a fundamentalinnovation in U.S. financial markets, providingbenefits to investors, the Treasury, and policymak-ers. Despite the potential benefits, the U.S. Treasuryhas never issued indexed bonds. In fact, only ahandful of industrialized countries, including theUnited Kingdom and Canada, have issued inflationindexed government bonds.This article discusses the benefits of inflationindexed Treasury bonds and points out some of theirlimitations. The first section shows how indexedbonds differ from conventional bonds. The secondsection discusses why investors, the Treasury, andpolicymakers would benefit from adding indexedbonds to the spectrum of U.S. Treasury debt instru-ments. The third section discusses some of thetechnical limitations of the bonds. The article con-cludes that, if carefully designed, inflation indexedTreasury bonds are likely to be beneficial.
An inflation indexed bond protects both investorsand issuers from the uncertainty of inflation overthe life of the bond.
Like conventional bonds,indexed bonds pay interest at fixed intervals andreturn the principal at maturity. The fundamentaldifference is that while conventional bonds makepayments that are fixed in nominal dollars (and thusare called nominal bonds), indexed bonds make pay-ments that are fixed in real terms (and thus are calledreal bonds). Because the purchasing power of fixednominal cash flows is reduced by inflation, nominalbonds expose both investors and issuers to the risk of changes in inflation, while real bonds do not.To understand the advantages of inflation indexedbonds over nominal bonds, it is useful to examinethe yield of a nominal bond under several inflationscenarios. For illustrative purposes, assume an in-vestor buys a $100, 10-year bond that pays interestannually and $100 at maturity. In the first scenario,which is characterized by zero inflation, the bond
Pu Shen is an economist at the Federal Reserve Bank of Kansas City. Corey Koenig, an assistant economist at thebank, helped prepare the article.
pays $3 in interest each year. Hence, the nominalyield of the bond is 3 percent.
The real (inflationadjusted) yield is also 3 percent because the realcash flow and the nominal cash flow are equal whenthere is no inflation.In the second scenario, inflation is assumed to be4 percent, but there is still no uncertainty aboutinflation. Because inflation erodes the purchasingpower of nominal payments, the relevant yield toexamine is not the nominal yield, but the real yield.The real yield
that corresponds to a nominalyield
when the actual inflation rate
is knownis given by the Fisher identity:
r = i - p
, which statesthe real yield equals the nominal yield less theinflation rate.
In this case, to keep the real yield onthe nominal bond at 3 percent, the same as underthe no-inflation scenario, the nominal yield on thebond has to rise to 7 percent
(i = r + p = 3 + 4)
.Thus, with positive inflation but no uncertaintyabout its level, bond issuers simply raise the nomi-nal coupon rate to 7 percent so that the real yield toinvestors (and real cost to issuers) remains the sameas in the zero-inflation scenario.
In the real world, however, inflation uncertaintycreates a risk for both investors and issuers. When-ever actual inflation differs from what was ex-pected, the real yield of the bond also differs fromwhat was expected. In the third scenario, actualinflation doubles to 8 percent soon after the bond isissued and remains steady for the life of the bond.In this case, investors lose since the real yield of thebond becomes a
1 percent (7 - 8 = -1),which is much less than the 3 percent expected byinvestors. By contrast, in the fourth scenario, actualinflation drops to 2 percent after the bond is issuedand remains steady. In this case, issuers lose sincethe real yield, and thus the real cost of servicing thebond, becomes 5 percent (7 - 2 = 5), which is muchmore than the issuers were prepared to pay.These last two scenarios illustrate the inflationrisk of nominal bonds. While the nominal yield of a bond can be adjusted to account for expectedinflation at the time the bond is issued, the bond’sactual real yield varies with actual inflation, whichcan be quite different from what was expected. If actual inflation rises unexpectedly, the real ratefalls; and if inflation declines unexpectedly, the realrate increases. Because it is impossible to knowwith certainty the actual rate of future inflation,inflation risk is intrinsic to nominal bonds andcannot be eliminated.In contrast to nominal bonds, inflation indexed orreal bonds have no inflation risk. By design, thenominal cash flow of a real bond is adjusted by thecumulative rate of inflation to insulate its real cashflow, and therefore its real yield, from changes ininflation. In other words, while a nominal bond’scash flow and nominal yield are adjusted by ex-pected inflation when the bond is issued, the couponpayments and maturity value of a real bond areadjusted over the entire life of the bond. The adjust-ment is made after inflation occurs to achieve thereal yield that investors and issuers agreed upon atthe time of issuance.Table 1 shows why indexed bonds have no infla-tion risk even when actual inflation differs fromwhat was expected. The table shows the real andnominal cash flows of a 10-year, $100 indexed bondthat has a 3 percent coupon rate under the fourinflation scenarios discussed above.
The real cashflow is shown just once since it is the same regard-less of the actual level of inflation. Notice that wheninflation is zero, the nominal cash flow and real cashflow of the indexed bond are exactly the same. Asinflation rises, both the nominal coupon paymentsand maturity value rise to maintain the 3 percentreal yield.
While indexing insulates all bonds from inflationrisk, the advantage of indexing is greater for long-term bonds than for short-term bonds, due mainlyto differences in inflation risk. Inflation risk forlong-term nominal bonds is significant, while infla-
tion risk for short-term nominal bonds is relativelyminor. One reason for this difference is that inflationis much easier to forecast in the short term.
In otherwords, the difference between actual and expectedinflation is much smaller for short-term forecasts of inflation. Another reason that short-term nominalbonds have less inflation risk is that changes ininflation will affect the value of a short-term bondmuch less than a long-term bond due to the effectof compounding. For example, consider two nomi-nal bonds that, for expositional simplicity, have nocoupon payments and pay back $100 at maturity.One bond has a one-year maturity and the other hasa ten-year maturity. With inflation at 4 percent, thereal principal of the 1-year bond is $96.15(100/1.04); with inflation at 8 percent, the realprincipal falls to $92.59 (100/1.08). Thus, for thisshort-term bond, the doubling of inflation reducesthe real value by less than 4 percent. For the 10-yearbond, in contrast, the doubling of inflation reducesthe real value of the bond from $67.56 (100/1.04
)to $46.32 (100/1.08
), which is a 37 percent decline.
Because long-term nominal bonds carry substantialinflation risk while short-term nominal bonds carrylittle inflation risk, investors and issuers are morelikely to be interested in long-term indexed bondsthan short-term bonds.
Surprisingly, few industrialized countries haveissued indexed bonds. Australia, Canada, Sweden,and the United Kingdom have issued indexed gov-ernment bonds (Table 2). New Zealand has indi-cated an interest in doing so.
The United Kingdomhas issued the greatest amount of indexed bonds.The UK government began issuing indexed bonds,called index-linked gilts, in 1981. Because short-term nominal bonds carry little inflation risk, it isnot surprising that the majority of indexed bonds inthe United Kingdom are long-term bonds with ma-turities of at least 15 years. Currently, there are 13such bonds outstanding, with (remaining) maturityranging from 2 to 35 years. The total face value of these indexed bonds is over 20 billion pounds, orabout 11 percent of the total face value of the UK’s
Table 1
Nominal cash flow under various inflation ratesYearReal cash flow 0 2 4 8
Note: Except for the last row, all of the cash flows are coupon payments. The nominal cash flow in year
when inflationis
equals the real cash flow times
+ p)

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