The Handbook of Financial Instruments

Chapter 8 Inflation-Indexed Bonds

John B. Brynjolfsson, CFA

Executive Vice President and Manager PIMCO Real Return Bond Fund

Historically, the greatest financial risk savers have faced has been inflation. During periods when too much money is chasing too few goods, savers’ financial needs inflate as the cost of living rises and their financial resources shrink as asset valuations are debased. In particular, rising inflation hits equities with a one-two punch, as higher input prices put downward pressure on earnings, and higher interest rates put downward pressure on price-to-earnings ratios. Meanwhile savers’ fixed income portfolios also suffer as rising market yields drive bond prices down, while accelerating inflation tends to make the inflation adjusted yield on cash instruments fall, or even become what turns out to be negative, when examined in retrospect.

There is good news however. Investors have a tool that mitigates the corrosive impact that inflation would otherwise have on their financial plans. That tool is Treasury Inflation Protection Securities (TIPS).¹

TIPS are bonds that are contractually guaranteed to protect and grow purchasing power. The U.S. Treasury adjusts TIPS’ principal based upon changes in the consumer price index (CPI) daily so that upon maturity investors maintain their original purchasing power.² In addition, the Treasury calculates the semiannual coupon payments based upon this indexed principal amount so that investors also maintain the purchasing ...