CHAPTER 2
Inflation-Protected Bonds as a Valuation Template
In the 1990s, the United States Treasury issued bonds where the coupon and principal were protected against changes in the Consumer Price Index (CPI). Patterned after similar securities issued in the United Kingdom in an earlier decade, the securities were named Treasury Inflation Protected Securities and given the acronym TIPS.
Traditional U.S. government securities pay a fixed-dollar coupon amount at stated intervals as well as a fixed-dollar principal amount at the earlier of maturity or call date. TIPS, however, pay both coupons and final principal amounts that are indexed for positive changes in the price level, typically as measured by the CPI.
In the 1920s, the classical economist Irving Fisher noted that traditional default-free securities—as U.S. Treasuries are considered to be—presented significant risk with respect to the purchasing power of a nominal unit of U.S. currency. Corporate equity securities, Fisher stated, should present much less of a purchasing power risk, although they would present a much greater risk, vis-à-vis the U.S. government, regarding ability and intent to pay out financial resources to investors.
By contrast, the insensitivity to purchasing power risk of corporate equity securities to changes in the general price level is predicated on basic microeconomic theory of the firm. In essence, a general rise in prices due strictly to changes in the amount of money in circulation—and to the ...
