When calculating returns to investments, it is important to take inflation rate into account, as it can erode your purchasing power per dollar. To provide investors more various options and protect them from negative impacts of inflation, an Inflation-Linked Bond (ILB) was designed. The first recorded ILB was issued in 1780 by the Common Wealth of Massachusetts, and Treasury Inflation Protected Securities (TIPs) are one sort of ILBs.
ILBs are bonds that adjust principal values in accordance with the changes in inflation rate. Let’s take an example of ILBs with 2% rate of return and a principal of $1000. If the inflation rate is 3% for the first year, the principal accrues $30 and becomes $1030. Then the coupon payment of the first year is a product of the principal including inflation accrual and the real rate of return, which is $51.
In the above case, an ILB with 2% real rate of return would yield the same amount as a normal bond with 5% normal rate of return. The difference of rates of returns between a normal bond and an ILB is named as Breakeven Inflation rate (BEI) in the sense that it is the interest rate that guarantees the same return for the two types of bonds, making investors indifferent between the two. BEI is said to be a leading indicator of the price level or CPI, as it reflects investors’ expectation of future inflation rate.
The easiest way to calculate BEI is taking the difference between the rate of return of a normal bond and the rate of return of an ILB with the same maturity. To be exact, add one to each rate of return and divide them. If a yield to maturity for a 10-year normal bond is 6% and that of a 10-year ILB is 3%, divide 1.06 by 1.03 and you get 2.91% for BEI. You can also compare a long-maturity bond with a short-maturity bond. As investors of a short-maturity bond, when they are expecting inflation, seek for reinvesting opportunities at a higher rate after it matures, a long-term maturity bond should have a high enough yield to maturity to be attractive for investors.
BEI provided by the Federal Reserve Bank is derived from 10-year Treasury Inflation-Indexed Constant Maturity Securities and 10-Year Treasury Constant Maturity Securities. Considering BEI and the related market situation, if you think BEI is far less than the expected inflation rate, then it is time to invest in ILBs.
Written by Ahrim Kim