CFAI reading 26, exhibit 5

[bluedragon]

Could somebody please explain me exhibit 5
Specifically how TIPS bond, and Nominal floating coupon bond’s coupon and princial is affected by inflation/deflation?

 

[olivier]

I don’t have the books with me, but:
* TIPS bonds are indexed on the official inflation rate ; that rate is almost always lower than actual inflation (the gov use gimmicks when computing inflation: http://www.huffingtonpost.com/kevin-phillips/washingtons-great-no-infl_b... ). So, your coupons are not actually indexed to the full extend of inflation and therefore underperform. The principal will also not keep up with inflation.
* Nominal floating coupon bond: To the extend that you believe that Nominal interest rate = Real interest rate + Inflation, your coupons would be protected against inflation thanks to the reset of interest rates. The principal still would not keep up with inflation.

 

[FRM2cfa]

Compare the yield available on a normal or “nominal” 10 year Treasury Bond to the TIP. A nominal 10 year Treasury yields 6.4%. If we subtract inflation, say 3.3% for the CPI, we get a “real yield” of 3.1% (6.4 - 3.3 = 3.1). Say the current yield of the TIPS is 3.3% “real”. This means that the real yield of the TIPS is 0.2% higher than the same term nominal Treasury. We can think of it another way. Add 3.3% inflation to the TIPS yield of 3.3% and we have a total yield of 6.6% which exceeds the nominal treasury yield of 6.4%.
As the inflation changes, the TIPS interest changes. For nominal bonds, interest remains same regardless of inflation.
One more thing, TIPS bond increases its principal by the changes in the Consumer Price Index (CPI). Its interest payment is calculated on the inflated principal, which is eventually repaid at maturity.