5-Year Treasury
Inflation-Indexed Security, Constant Maturity.
However, a large share of TIPS activity occurs via "breakeven inflation" trades, whereby a particular
inflation-indexed security is traded against a proportionate quantity of a particular nominal security.
The first section broadly describes the
inflation-indexed security programs in a number of developed countries and highlights some of their common features.
On average it may be 3.5 percent, but there is an inflation risk associated with holding this bond that does not exist with an
inflation-indexed security such as TIPS.
The evidence presented here does not support my first hypothesis as the yield spread, the yield on a conventional Treasury note minus the yield on a Treasury
inflation-indexed security, has not been a useful proxy for the rate of inflation.
Equation (2) states that the break-even inflation rate, [??]--that is, the expected rate of inflation at which the two securities trade at the same price--can be approximated by the difference in the yields to maturity between a nominal and an
inflation-indexed security. For securities of more than one year to maturity, matters are more complex but the same principle applies.
[rho]: Real long-term default-free rate, measured by the yield of the on-the-run 10-year Treasury
inflation-indexed security; daily; source: New York Times.
An important real rate, which is thought to have a particular influence on investment spending, takes a common callable bond, the 30-year GNMA, and subtracts, as an inflation estimate, the yield difference between a 10-year Treasury bond and a 10-year Treasury
inflation-indexed security. This option-adjusted rate (dubbed the "Berk rate" after the economist who developed the idea) has decreased lately, falling about 23 bp since mid-October.
Example 1: A $100,000 face value
inflation-indexed security issued at par in January 2001 bears 5% interest and matures in four years.
This paper compares efficient portfolios containing an
inflation-indexed security to portfolios without such a security.
Because the payments automatically adjust to compensate for inflation, the yield on an
inflation-indexed security reflects the real rate of return that would be realized over the maturity of the security.
A final consideration in valuing TIIS is that the securities offer deflation protection, in the sense that the cumulative adjustment to the principal amount of the
inflation-indexed security at maturity cannot be negative.
