Inflation Linked Bonds and Breakeven Rates

TIPS principal adjusts with CPI, and the gap between nominal and real yields sets the breakeven rate the market prices for inflation.

An inflation-linked bond adjusts its principal in line with a published price index, so the coupon and final redemption both rise with realized inflation rather than being fixed in nominal terms. Comparing the yield on an inflation-linked bond to the yield on a nominal bond of the same maturity produces the breakeven inflation rate, the average annual inflation rate at which an investor would be indifferent between holding the two instruments.

In the United States, Treasury Inflation-Protected Securities, commonly called TIPS, adjust their principal value using the non-seasonally adjusted Consumer Price Index, applied with a roughly two to three month lag because the index for a given month is not published until partway through the following month. The bond's coupon rate stays fixed, but since it is paid on the inflation-adjusted principal rather than the original face value, the actual cash coupon paid rises and falls with the accumulated inflation adjustment.

At maturity, most inflation-linked government bonds guarantee repayment of at least the original face value even if the price index has fallen since issuance, a floor commonly called deflation protection. That floor is not free, and it is one of the reasons an inflation-linked bond's real yield can differ slightly from a pure, unguaranteed inflation-linked cash flow stream, particularly for bonds issued when deflation risk was priced as a meaningful possibility.

The breakeven inflation rate is calculated as the nominal yield on a conventional bond minus the real yield on an inflation-linked bond of the same maturity, both bonds issued by the same government so that credit risk cancels out of the comparison. A ten year nominal Treasury yielding 4.30 percent against a ten year TIPS yielding a real 2.00 percent implies a ten year breakeven inflation rate of approximately 2.30 percent, the average annual inflation rate over the coming decade that would make an investor indifferent between the two bonds.

That breakeven figure is often treated informally as the market's inflation forecast, and it does carry real information about inflation expectations, but it is not a pure forecast. It also bundles in an inflation risk premium, the extra compensation nominal bondholders demand for bearing inflation uncertainty that TIPS holders are protected against, and a liquidity premium, since TIPS trade in smaller volume than nominal Treasuries and can command a modestly different liquidity discount depending on market conditions.