Question

A bond investor concerned about inflation is most likely to consider which of the following investments?

Multiple Choice

• U.S. Treasury bond

• Corporate bond

• TIPS bond

• Mortgage bond

Answer 1

Any bond investor would worry about inflation as in case inflation rise, it would also increase the nominal interest rate. Thus, Yield to Maturity of every bond would rise. As we know that YTM and bond price has inverse relationship. In case, YTM rises bond price would fall. It will hurt investor. So, investors are worried about rising inflation as it would give them loss in fair value of the bond. In case investor won't like to keep this untill maturity, it would decrease its ultimate return.

Similarly, in case of inflation fall, YTM would fall means any investor who wanted to keep this bond till maturity his return would decrease. Thus, in any case inflation would hurt bond holder given what is the holding period of investor. So, a person who is woried about inflation, he should buy TIPS bond. So, Option (c) is correct. Proper reason are as follows:

(a) U.S. Treasury Bonds: Since their coupon payments are not linked to inflation, coupon payments are fixed. Thus, inflation would have direct bearing on bond holders as explained earlier. Thus, it does not allivieate the concerns of investor with regards to inflation.

(b) Corpoarte Bonds: Similar to U.S. Treasury Bonds, their coupon payments are also fixed. Thus, it also not allivieate the concerns of investor with regards to inflation.

(c) TIPS Bond: TIPS bonds are Treasury Inflation Protected Notes. Their coupon payments are linked to inflation in the economy which is measure by any benchmark i.e. Consumer Price Inflation or some other benchmark. Thus, in case inlfation rise, coupon payments rise. Thus, it doesn't impact much on investor. It helps the investor who is worried about inflation.

(d) Mortgage Bonds: These bonds are similar to other bonds having fixed coupon payments and thus, doesn't help in removing inflation risk of investor.

So, Option (C) i.e. TIPS bonds is correct.