Thursday, 4 December 2008

A short note on the yield of inflation-linked bonds

Some people recently seem confused by the yield of some inflation linked bonds. Here's the scoop.

1. Some, but not all, inflation linked bonds are floored at zero inflation on principal. That is, you cannot get less than the face value back. TIPS, for instance, have this feature.

(2. There is a more extreme form of flooring where the coupon is floored at the stated real yield on the face, so for instance if you hold a 2.5% real yield bond where the face has accrued to $1M, then you will always get a coupon of at least $25,000. This form of floor is rare, so I will ignore it.)

3. This means that in effect these floored bonds are a pure inflation-linked bond together with a floor. The strike of the floor depends on inflation to date. To see this, suppose we have an old TIPS. Experienced inflation over its life will have inflated its market price way above par. Thus inflation has to be highly negative for the floor to be worth anything. For a newly issued TIPS, on the other hand, the floor is much closer to the money.

4. When inflation was expected to be 3 or 4% a year, this didn't really matter much. But with deflation expected in 2009 by some, you really need to adjust the yield of short dated newly issued floored bonds by the value of the embedded inflation floor, as this floor is now quite valuable.

5. This is in theory a simple option adjusted spread problem. I say in theory because in some markets - the UK is a good example - there is an oversupply of inflation caps which means that market quoted inflation volatilities are not reliable. But this isn't an issue for TIPS. Simply [;-)] go to your friendly broker, get a quote for the correct strike inflation floor, back out the vol, then use this to option adjust the spread of your bond.

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