Back in 1997, the U.S. government issued Treasury Inflation-Protected Securities (TIPS), which are backed by the credit and full faith of the government and guarantees that their value will not be eroded by inflation; thus, providing risk-free asset for investors in the U.S.
Both TIPS face value and coupon payments are indexed to keep up with inflation and to protect buying power, while their returns are set in real inflation-adjusted terms.
Under positive inflation (versus deflation) conditions, actual returns are below the nominal gains quoted on traditional (without inflation adjustment) bonds. Estimating for the real interest rate, we get:
real interest rate = nominal interest rate - expected inflation rate
Or, to be more exact, the actual formula using these variables will be:
(1 + nominal interest rate) = (1+ real interest rate) * (1 + expected inflation rate)
We determine nominal interest rates by adding the compensation expected to keep up with inflation and a real interest rate of return for the investment. Surely, bond prices and interest rates can be impacted by supply and demand. And real interest rates may take a negative value, as mentioned above.
Of course, investors hope for a positive nominal return on investment (the very reason for investing, obviously); however, the gain might not catch up with the inflation rate. TIPS, compared to conventional bonds, provide returns which are quoted as real interest rates.
TIPS nominal returns cannot be predicted in advance since they are determined by the actual inflation experienced. It also follows that nominal returns can be determined for conventional bonds; however, their real returns can only be determined after monitoring the realized inflation track until the maturity date.
Adjustments of inflation for TIPS are set to the Consumer Price Index for All Urban Consumers (CPI-U). Such adjustments are observed according to the “accrued principal,” a dedicated term used for TIPS.
Accrued principal is the value after due adjustment for inflation of the original face value at the time the TIPS was issued. Inflation adjustments for TIPS are achieved through the coupon rate being paid on the accrued principal value, not on the value of the nominal initial face.
Likewise, during maturity, the investor gets back the accrued principal, not the nominal face amount. An inflation-adjusted value is paid at a real coupon rate and an inflation-adjusted value is paid at maturity.
During deflation, the accrued principal can go down; however, it is protected against dipping below its original par value. What this signifies is that TIPS on the secondary markets having lower accumulated principal can provide higher protection during deflation, considering all other factors unchanged.
On the other hand, deflation that is not substantial enough to make the accrued principal to drop below its original par value will adversely affect TIPS in relation to conventional bonds. As a general rule, the goal of TIPS is to protect investments from unpredictably high inflation; thus, acquiring TIPS with a lower relative accrued principal is a supplementary factor in selecting certain TIPS to buy.
TIPS are available in nominal dollars. The ask price for TIPS on the secondary market is set in real terms, quoted as a percentage value of the accrued principal after adjustment for inflation. The actual price paid is computed as the ask price multiplied by the accrued principal, then divided by 100.
Since 1997, TIPS bonds and notes have been issued. From that time until the middle of 2002, every TIPS auction covering different maturities yielded an initial real return over 3%.
Fortunate investors in 1998 and 1999 could have acquired 30-year TIPS giving almost 4%, while 10- and 20-year TIPS gains were more than 4% in 1999 and 2000. TIPS yields have dropped since then.
A TIPS auction for a five–year note conducted in October 2010 made news as the real yield dropped below zero (at negative 0.55%) only for the first time. Buyers of such issues have resigned themselves to returns not protected from inflation.
Although unusual then, negative returns for TIPS have recently become a more common occurrence nowadays.