Benefits and Limitations of Inflation Indexed Treasury Bonds

By Shen, Pu | Economic Review - Federal Reserve Bank of Kansas City, Third Quarter 1995 | Go to article overview

Benefits and Limitations of Inflation Indexed Treasury Bonds


Shen, Pu, Economic Review - Federal Reserve Bank of Kansas City


In recent years, members of Congress and academia have repeatedly urged the U.S. Treasury to issue some portion of its debt in the form of inflation indexed bonds. With an indexed bond, the interest and maturity value are adjusted by the rate of inflation over the life of the bond. Because the cash flow of an indexed bond is adjusted for inflation, the bond's real value does not vary with inflation, protecting investors and issuers alike from inflation risk.

Inflation indexed bonds would be a fundamental innovation in U.S. financial markets, providing benefits to investors, the Treasury, and policymakers. Despite the potential benefits, the U.S. Treasury has never issued indexed bonds. In fact, only a handful of industrialized countries, including the United Kingdom and Canada, have issued inflation indexed government bonds.

This article discusses the benefits of inflation indexed Treasury bonds and points out some of their limitations. The first section shows how indexed bonds differ from conventional bonds. The second section discusses why investors, the Treasury, and policymakers would benefit from adding indexed bonds to the spectrum of U.S. Treasury debt instruments. The third section discusses some of the technical limitations of the bonds. The article concludes that, if carefully designed, inflation indexed Treasury bonds are likely to be beneficial.

WHAT ARE INFLATION INDEXED BONDS?

An inflation indexed bond protects both investors and issuers from the uncertainty of inflation over the life of the bond.(1) Like conventional bonds, indexed bonds pay interest at fixed intervals and return the principal at maturity. The fundamental difference is that while conventional bonds make payments that are fixed in nominal dollars (and thus are called nominal bonds), indexed bonds make payments that are fixed in real terms (and thus are called real bonds). Because the purchasing power of fixed nominal cash flows is reduced by inflation, nominal bonds expose both investors and issuers to the risk of changes in inflation, while real bonds do not.

To understand the advantages of inflation indexed bonds over nominal bonds, it is useful to examine the yield of a nominal bond under several inflation scenarios. For illustrative purposes, assume an investor buys a $100, 10-year bond that pays interest annually and $100 at maturity. In the first scenario, which is characterized by zero inflation, the bond pays $3 in interest each year. Hence, the nominal yield of the bond is 3 percent.(2) The real (inflation adjusted) yield is also 3 percent because the real cash flow and the nominal cash flow are equal when there is no inflation.

In the second scenario, inflation is assumed to be 4 percent, but there is still no uncertainty about inflation. Because inflation erodes the purchasing power of nominal payments, the relevant yield to examine is not the nominal yield, but the real yield. The real yield (r) that corresponds to a nominal yield (i) when the actual inflation rate (p) is known is given by the Fisher identity: r = i - p, which states the real yield equals the nominal yield less the inflation rate.(3) In this case, to keep the real yield on the nominal bond at 3 percent, the same as under the no-inflation scenario, the nominal yield on the bond has to rise to 7 percent (i = r + p = 3 + 4). Thus, with positive inflation but no uncertainty about its level, bond issuers simply raise the nominal coupon rate to 7 percent so that the real yield to investors (and real cost to issuers) remains the same as in the zero-inflation scenario.(4)

In the real world, however, inflation uncertainty creates a risk for both investors and issuers. Whenever actual inflation differs from what was expected, the real yield of the bond also differs from what was expected. In the third scenario, actual inflation doubles to 8 percent soon after the bond is issued and remains steady for the life of the bond. …

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