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.
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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 percent 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.
Now let's look at the specific characteristics of these
unique bonds a little more closely.
