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For fixed income investors, inflation can be a nemesis. Since the payout on traditional U.S. Treasury bonds is static, increases in the price level erode real (inflation adjusted) returns. For that reason, in 1997 the U.S. Treasury created TIPS or Treasury Inflation Protected Securities that adjust automatically to protect the purchasing power of the cash flow stream. TIPS bonds have proven to be popular with investors, and have also served as a valuable tool in assessing the market's perception of future inflation.

The idea of indexing a bond to an inflation measure like the Consumer Price Index is not a new one. The first known inflation indexed bonds were issued by the Commonwealth of Massachusetts during the Revolutionary War. These bonds were issued as compensation to soldiers in lieu of cash salary and were known as "soldiers' depreciation notes," structured to compensate payees for the loss of their purchasing power during a period of high inflation. Several other instances over the next two centuries enjoyed only limited success until sovereign governments began adopting the concept in the post-war years. In 1997, the U.S. Treasury announced the creation of the first American Government bond indexed for inflation.

In general, Treasury bonds pay a fixed interest rate (called the coupon rate) over the life of the bond. The coupon payment amount is computed based upon the rate and the principal or par value of the bond. At maturity, the final coupon payment is received along with the par value.

With TIPS bonds, the coupon rate is also fixed and does not change. However, the principal value is adjusted up or down based upon changes in the Consumer Price Index (CPI). Inflation causes the principal to increase, while deflation (falling prices) causes principal to adjust downward. Following the adjustment, coupon payments are computed using the new principal values, which means that both the par value and the amount of the interest payments vary with price changes in the economy. TIPS carry an implicit guarantee backed by the full faith and credit of the United States, just like conventional Treasury bonds.

some text Christopher A. Hopkins

Inflation-indexed bonds have also proven to be a useful indicator of expected inflation. Conventional Treasuries have a built-in imputed inflation rate, the so-called inflation risk premium that investors stack on top of the "real" pre-inflation yield. Since by definition TIPS adjust for inflation in real time, they have no implicit inflation risk premium. Therefore, comparing the yield to maturity on comparable ordinary and inflation-adjusted bonds of the same maturity provides a good indication of the expected rate of inflation perceived by investors. The difference between these two market-based yields is called the "break-even rate," and can be interpreted as the inflation rate at which TIPS and Treasury bonds each produce the same inflation-adjusted return. As of September 20, the break-even inflation rate on the 10-year maturity was 1.61%, representing the anticipated 10-year average annual change in the CPI.

Treasury currently issues TIPS in 5-, 10- and 30-year maturities. The bonds pay interest every six months, calculated as the adjusted principal value times of the coupon interest rate. As of 2018, roughly 9% of all U.S. government bonds were inflation adjusted.

TIPS can be purchased through banks, brokers and directly from the U.S. Treasury at TreasuryDirect.gov. The minimum denomination is $100. There is also an active secondary market for TIPS, providing investors with liquidity should they wish to sell their bonds.

They won't make you rich. But for investors who anticipate higher inflation and who seek the security of Treasuries, TIPS can play a role.

Christopher A. Hopkins, CFA, is a vice president of portfolio manager for Barnett & Co. in Chattanooga.

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