Chapter 2. Inflation-Protected Securities

Inflation-protected securities are also known as real return bonds because they provide a guaranteed real (inflation-adjusted) return. Nominal return bonds are not adjusted for inflation. (To determine the real return of a nominal return bond, subtract the rate of inflation experienced over the relevant time period from the nominal return.)

Real return bonds offered by the U.S. Treasury convey benefits that will interest most investors:

  • They insulate investors from the risks of unexpected inflation.

  • They are generally less volatile than nominal return bonds of similar maturity.

  • They have lower correlations to equities than nominal return bonds, making them more effective diversifiers of equity risk.

  • They have no credit risk.

The U.S. government issues two types of real return bonds: Treasury inflation-protected securities (TIPS) and inflation-linked savings bonds (I bonds). TIPS are sold at auction and receive a fixed real rate of return. The principal is adjusted for inflation before the fixed-interest payment is calculated. Like TIPS, I bonds provide a fixed real rate of return and an inflation-protection component. However, there are significant differences between these securities, which we will elaborate on in this chapter.

Unlike many of the investments covered in this book, TIPS and I bonds can be purchased directly at little to no cost. Buying individual TIPS gives investors the ability to control the maturity of their holdings, a considerable ...

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