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Case Write-up #2: Innovation at the Treasury: TIPS
Federico Martinoli
1) TIPS are an inflation-indexed form of debt: they are 10 year treasury notes with semiannual coupon payments. Both the principal and the coupons are adjusted every semester by the percentage raise of the Consumer Price Index (CPI). Therefore if a CPI has a nominal value of 100 and pays 2% interest and the CPI raises by 5% the principal will become USD 105 and the coupon will be USD 2.1 (so the interest rate against the principal remains 2% but it becomes 2.1% of the original face value of the bond). To the contrary in case of deflation the TIPS would never fall below the face value. Different types of inflation indexed securities are sold by other governments like the UK, Brazil, Chile, Israel, Australia, etc.). This is not the only possible way to structure an inflation-indexed bond. A bond could be structured to only adjust its coupon and not the principal, or it could also be structured to adjust for deflation. TIPS are probably the best structure for small investors that are investing their savings for their retirement or for their kid’s college as they adjust both principal and coupon only upwards. 2) The price of TIPS is affected by the current yield of other forms of government securities and in general by the economic condition of the issuing country. In fact if the issuing country goes into a recession and the yields of the various treasuries rise also the TIPS yield will rise causing the TIPS bond price to fall and vice-versa in a case of economic improvement. Changes in the expectation of future inflation may also influence the TIPS. This is because TIPS trade at a discount with respect to a non-TIPS treasury with the same maturity. Therefore if the expectation of future inflation rises investors will accept an even higher discounts in order to cover the inflation risk making the

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