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Course 207
Treasury Inflation-Adjusted Securities

Introduction

People often choose to invest in United States Treasury-backed securities because of the bonds' safety from default. One disadvantage of investing in bonds had always been the risk of losing purchasing power as the result of inflation. For this reason, the U.S. Treasury developed a new type of security--the inflation-adjusted bond.

Bond and Inflation Basics

Here are a few terms common to all types of bonds.

The principal is the amount you originally invest in the bond, which represents a loan made to the organization issuing the bond. The face amount of a bond is due to be repaid when it matures. If you hold your bond until it matures, you get back your entire principal unless the bond defaults.

Treasury inflation-adjusted bonds are adjusted based on the Consumer Price Index (CPI-U). The CPI-U measures the average change over time in the prices urban consumers pay for a given "basket" of goods and services. As prices continuously increase over time, the purchasing power of the consumer's dollar declines. This is called inflation. The CPI-U is the most widely used measure of inflation. The Bureau of Labor Statistics of the US Department of Labor publishes the CPI-U monthly.

What Is an Inflation-Adjusted Security?

Because the purchasing power of your dollar decreases over time as a result of inflation, the rate at which your investments grow must exceed the inflation rate in order for you to experience real gains. Straight bonds pay their interest on a fixed principal amount. The principal amount is repaid at maturity. By the time this happens, this amount will not be worth as much in "real" dollars as it was when you first invested it. Inflationary risk is a major concern for investors of regular bonds because the purchasing power of the principal will decrease over time.

An inflation-adjusted security remedies this problem by adjusting the dollar value of the bond's principal to inflation. The bond increases its principal by an amount based on the non-seasonally adjusted CPI-U. The inflationary level when a bond is first issued is known as a bond's reference CPI-U. Because inflation for a given month is not actually known until two months later, a bond's reference CPI-U is the same as the CPI-U three months before the bond is issued. To arrive at the bond's inflation-adjusted value, the bond's principal is multiplied by the CPI-U index ratio (the current CPI divided by the bond's reference CPI).

For example, you buy a 10-year, $1,000 Treasury inflation-adjusted bond in April. The CPI reference rate is taken from January's CPI (three months earlier), which is 100. Six months later, inflation has risen 1% and the current CPI is now 101. This gives you a CPI index ration of 101/100, or 1.01. Your bond's principal is now worth $1,010, or 1,000 x 1.01.

At its maturity, the bond pays either the inflation-adjusted principal or the original principal amount, whichever is higher. The bond's semi-annual interest payments are calculated with a fixed rate of interest on its inflated principal, guaranteeing that the investor earns, on the original investment amount, a rate of return higher than inflation. The interest rate of the bond is established at issue.

Characteristics of Inflation-Adjusted Securities

What happens to an inflation-adjusted bond if the economy experiences decreased prices over time? If there is deflation, the bond's principal will decline, but not below its par value. Remember that when the bond matures, you are guaranteed to receive either its inflation-adjusted principal or its original principal, whichever is higher.

Treasury inflation-adjusted securities are issued in denominations and multiples of $1,000. So far, the Treasury has issued inflation-adjusted securities with maturities of only five or ten years, but will be adding thirty-year maturities in the future. Like other Treasury bonds, new inflation-adjusted bond issues are sold by auction through the Treasury Direct program on a quarterly basis. There is no certificate issued when you buy one of these bonds from the U.S. Treasury. The Treasury issues and maintains the bonds at their par value in bank accounts through accounting entries or electronic records.

Treasury inflation-adjusted securities will soon be eligible to participate in the Separate Trading of Registered Interest and Principal of Securities (STRIPS) program. Through this program, the bond investor "strips" the coupon interest payments from the bond and sells them, leaving the principal of the bond to be sold at a discounted price.

Advantages of Inflation-Adjusted Securities

Treasury inflation-adjusted bonds are backed by the full faith and credit of the US government. Because the principal is protected from inflation by being indexed with the CPI-U, the real purchasing power of your investment will keep up with rising prices. The market prices of these bonds can be affected only by changes to real, rather than nominal, interest rates. Real interest rates are those that are adjusted for inflation.

The second advantage to these bonds is that the principal of a bond at the time of purchase is guaranteed to an investor who holds the bond until maturity. An investor who buys a bond at a price equal to its inflation-adjusted par can expect its real yield to equal its coupon rate if it is not sold.

The safety of inflation-adjusted securities makes them an especially worthwhile investment for long-term investors who wish to live off the steady interest income and maintain the purchasing power of that income. Similarly, the investor is assured to receive back the principal with the same purchasing value it had when it was originally invested.

Issuing inflation-adjusted securities also benefits the Treasury department because it reduces its initial interest costs.

Taxation of Inflation-Adjusted Securities

Interest income earned on an inflation-adjusted bond is taxed as ordinary income by the IRS. There is no distinction between inflation-adjusted income and nominal income. The appreciation of principal and the semi-annual fixed interest on these bonds are taxed in the year they are accrued (earned), even though an investor will not actually receive the principal increases until the bond matures. These increases are sometimes referred to as "phantom income." This means that when inflation increases, so do the taxes on inflation-adjusted bonds. There is a risk that in years of high inflation, tax liability could exceed your coupon interest income, wiping out your yield.

If the economy experiences deflation, the deflation offsets interest earned on the bond. If deflation is greater than the interest earned, the unused portion of interest can be carried forward to offset future income. If the deflation amount is not used by the bond's maturity, the bondholder may claim it as a capital loss.

Like other Treasury bonds, Treasury inflation-adjusted bonds are exempt from state income taxes.

Invest in the Treasury and Beat Inflation, Too

The market for U.S. Treasury securities is actively and highly liquid. As a new type of security, inflation-adjusted securities may not be as well developed and understood as other types of Treasury securities. This could result in larger spreads between what a dealer is willing to pay for an inflation-adjusted security and what sellers are willing to sell them for, leading to higher costs for the common investor. There are still unknowns associated with Treasury inflation-adjusted securities not ordinarily associated with other Treasury notes.

For example, what happens if the structure of the CPI-U index is changed? But regardless of the uncertainties, there is no doubt that these unique bonds are one of the safest types of investments you can buy.

Quiz 207
There is only one correct answer to each question.

1 In periods of deflation, inflation-adjusted securities will....
a. Increase in value
b. Decrease in value
c. Stay the same in value
2 What is the main advantage of inflation-adjusted securities?
a. They will help you reduce your taxes
b. They offer an investment that maintains its purchasing power
c. They are not affected by interest rates
3 Which of the following will happen if you earn interest on an inflation-adjusted bond?
a. The income is tax-deferred
b. The income is taxed as ordinary income by the IRS
c. You only have to pay tax on coupon interest, not principal interest
4 Which of the following measures the effects of inflation?
a. Par value
b. The Treasury
c. The CPI-U
5 The process of selling a bond's coupons and principal separately is called...
a. Stripping
b. Adjusting
c. Underwriting
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