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Thndr Claps » Thndr Thinkers💭 » Hany Genena » Treasury Inflation-Protected Securities

Treasury Inflation-Protected Securities

by Thndr Thinker
September 18, 2022

A simplified example to illustrate the idea:

The US government offered a $100 bond for one year (it’s called a bill in this case, but for simplicity, we will call it a bond).

Interest = 5%

After a year, the investor is worth $105 (principal + interest).

If inflation = 5%, then the real return:
Real interest rate = (1 + 5%)/(1 + 5%) – 1 = 0
The 5% above = interest, and the below = inflation rate.

So in this example, the investor’s purchasing power has not increased after a year because the year-end inflation rate = the nominal interest rate that was agreed upon at the beginning of the year.

But bonds insured against risk are as follows:

The same example, but the original and interest will be modified as follows:
1.  After a year, the value of the asset will be increased by the rate of inflation.
Inflation-adjusted principal = 100 x (1.05) = 105

2. Also after a year, the interest paid will be calculated based on the adjusted principal and not the face value of the bond at issue = $100, if:
Inflation adjusted interest = 5% x 105 = 5.25

Please note that the interest rate has not changed (5%) but is 5% of a larger principal and thus became 5.25 instead of only $5.

So, after a year, the investor will receive:

Principal = 105 + Interest = 5.25 = 110.25
As if the nominal interest rate was 10.25%.

Now, the real interest can be calculated
Real Interest Rate = (1+10.25%)/(1+5%) – 1 = 5%

The investor is fully insured against rising inflation and the nominal interest is equated to the real interest.

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