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.