Question

4. If the coupon rate of an inflation protection bond (TIPS) is 1.75% and it is sold at par or $1,000. What is the annual real return on this bond for a buy and hold investor. This bond should provide the same real return during inflationary and deflationary periods. YES, or NO, circle one and explain below.

Answer 1

What is TIPS?

• TIPS are a type of treasury bond that is indexed to protect investors from the decline in the purchasing power of their money due to inflation.
• During inflation, TIPS Principal Value Increases due to which interest payment increases.
• During deflation, TIPS Principal Value Decreases due to which interest payment decreases.
• The real Coupon Rate is always the same.
• The principal amount is protected since investors will never receive less than they originally invested in principal.

Annual Real Return on this type of bond can be calculated in the following manner.

Let Take an Example

Example 1

A $1000 par value TIPS with a 5% coupon would initially generate a return of $50. Let Inflation is 10%. Then inflation-adjusted the par value to $1100, the coupon payment would instead be $55 ($1100 x 5% = $55, $55 = 50 * 1.1).

· Suppose the TIPS were trading at $925 on the secondary market. The real yield calculation would use the secondary market price (like any other bond) of $925, but use the inflation-adjusted coupon payment of $55. The real yield would be 5.94% (55 ÷ 925).

· Suppose the TIPS were trading at $1075 on the secondary market. The real yield calculation would use the secondary market price (like any other bond) of $1075, but use the inflation-adjusted coupon payment of $55. The real yield would be 5.11% (55 ÷ 1075).

Example 2

A $1000 par value TIPS with a 5% coupon would initially generate a return of $50. Let Deflation is 10%. Then inflation-adjusted the par value to $900, the coupon payment would instead be $45 ($900 x 5% = $45, $45 = 50 * 0.9).

· Suppose the TIPS were trading at $925 on the secondary market. The real yield calculation would use the secondary market price (like any other bond) of $925, but use the inflation-adjusted coupon payment of $45. The real yield would be 4.86% (45 ÷ 925).

· Suppose the TIPS were trading at $1075 on the secondary market. The real yield calculation would use the secondary market price (like any other bond) of $1075, but use the inflation-adjusted coupon payment of $45. The real yield would be 4.18% (45 ÷ 1075).

Conclusion: So, to calculate the Annual Real Return, we required Inflation and Secondary Market Price, which is Not Available. However, it is Sure that Real return is more than coupon during inflation and lower during deflation. Hence bond should not provide the same real return during inflationary and deflationary periods.

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