Fundamentals of Financial Management (Concise 6th Edition)

Chapter 6 Interest Rates 171

reported! gures might show an annual in" ation rate of 3% over the past 12 months,
but that is for the past year. If people, on average, expect a 4% in" ation rate in the
future, 4% would be built into the current interest rate. Note also that the in" ation
rate re" ected in the quoted interest rate on any security is the average in! ation rate
expected over the security’s life. Thus, the in" ation rate built into a 1-year bond is the

Investors who purchase bonds must constantly worry about
in" ation. If in" ation turns out to be greater than expected,
bonds will provide a lower-than-expected real return. To
protect themselves against expected increases in in" ation,
investors build an in" ation risk premium into their required
rate of return. This raises borrowers’ costs.
To provide investors with an in" ation-protected bond
and to reduce the cost of debt to the government, the U.S.
Treasury issues Treasury In" ation Protected Securities (TIPS),
which are bonds that are indexed to in" ation. For example,
in 2004, the Treasury issued 10-year TIPS with a 2% coupon.
These bonds pay an interest rate of 2% plus an additional
amount that is just su# cient to o! set in" ation. At the end of
each 6-month period, the principal (originally set at par or
$1,000) is adjusted by the in" ation rate. To understand how
TIPS work, consider that during the $ rst 6-month interest
period, in" ation (as measured by the CPI) was 2.02%. The
in" ation-adjusted principal was then calculated as $1,000(1 #
In" ation) " $1,000 $ 1.0202 " $1,020.20. So on July 15,
2004, each bond paid interest of 0.02/2 $ $1,020.20 "
$10.202. Note that the interest rate is divided by 2 because
interest on Treasury (and most other) bonds is paid twice a
year. This same adjustment process will continue each year
until the bonds mature on January 15, 2014, at which time
they will pay the adjusted maturity value. Thus, the cash
income provided by the bonds rises by exactly enough to
cover in" ation, producing a real in" ation-adjusted rate of 2%

for those who hold the bond from the beginning to the end.

Further, since the principal also rises by the in" ation rate, it

too is protected from in" ation.

Both the annual interest received and the increase in

principal are taxed each year as interest income even though

cash from the appreciation will not be received until the

bond matures. Therefore, these bonds are not good for

accounts subject to current income taxes; but they are excel-

lent for individual retirement accounts (IRAs) and 401(k)

plans, which are not taxed until funds are withdrawn.

The Treasury regularly conducts auctions to issue

indexed bonds. The 2% rate was based on the relative supply

and demand for the issue, and it will remain $ xed over the life

of the bond. However, after the bonds are issued, they con-

tinue to trade in the open market; and their price will vary as

investors’ perceptions of the real rate of interest changes.

Indeed, as we can see in the following graph, the real rate of

interest on this bond has varied quite a bit since it was issued;

and as the real rate changes, so does the price of the bond.

Real rates fell in 2005, causing the bond’s price to rise; rates

then rose to a peak in 2007, at which point the bond sold

below its par value. They fell again in late 2007 and 2008 as

investors sought safety in Treasury securities. Thus, despite

their protection against in" ation, indexed bonds are not com-

pletely riskless. The real rate can change; and if r* rises, the

prices of indexed bonds will decline. This con$ rms again that

there is no such thing as a free lunch or a riskless security.

Source: St. Louis Federal Reserve web site, FRED database, http://research.stlouisfed.org/fred2.

AN ALMOST RISKLESS TREASURY BOND

r*

(%) 10-Yr. 2% Treasury In"ation-Indexed Note, Due 1/15/2014

3.00

0.00

1-12-04 1-12-05 1-12-06 1-12-07 1-12-08

0.50

1.00

1.50

2.00

2.50