As the Federal Reserve raises rates to combat rising inflation, the consumer price index soared to another 40-year high as prices rose 9.1% in June. Inflation has investors worried, so let’s take a step back and review key related concepts and debunk an important myth.
Nominal and real frameworks
“A nickel ain’t worth a dime anymore” – Yogi Berra
Which would you prefer: a 2% pay rise with inflation at 4% or a 2% pay cut when inflation is at zero? Although both scenarios amount to the same thing, it is likely that the first option would be more acceptable than the second.
Arguably, the key concept associated with inflation is the following mantra: “investors should care about goods and services that money can buy, not money itself”.
A nominal framework is referring to the amount of cash an investor might own. A real framework asks what goods and services cash will buy. Humans are susceptible to money illusion, which refers to a tendency to think in nominal rather than real terms. Research suggests that this tendency persists even in the light of education. People tend to resort to analysis in real terms when inflation is high but rely on nominal evaluations when inflation subsides.
With respect to a financial investment, if a 1-year bond at par pays a single 5% coupon at the end of the period, then the nominal return is 5%. The real return depends on what happens to inflation over the period. If inflation is 3% then the real return is about 2% (or 1.94% to be precise). In this scenario, the consumer would be able to afford about 2% more goods and services at the end of the period than at the start.
The Fisher Equation
The key to analyzing inflation markets is the Fisher equation. In simple terms it states:
- Nominal yields (n) = real yields (r) + expected inflation (f) + risk premium (p - for unexpected inflation)
- Over the years, the equation has been simplified by the market to read:
- Nominal yields = real yields + breakeven spread
Real yields signal how much today’s savings are worth in terms of future consumption. The breakeven spread is not a “true” measure of the market’s expectations of future inflation. This is because it includes the risk premium for unexpected inflation, which is impossible to disaggregate from views on expected inflation. As a result, the breakeven spread represents the level of realized inflation that would have to trade to make an investor indifferent between buying an inflation-linked bond (ILB) and a nominal equivalent.
These are sometimes referred to as TIPS (Treasury Inflation Protected Securities), although their formal designation is “Treasury Inflation Indexed Securities.” The main purpose of an inflation-linked bond is to provide real value certainty.
Inflation-linked bonds trade on a real basis: real coupons, real prices and real yields. Take, for example, the 2.375% of January 2025, which was issued on the 15 of July 2004. As of the time of writing (mid-July 2022) the bond was trading at a clean price of 105.349, implying a real yield to maturity of 0.232%. The bond had 178 days of real accrued coupon, meaning its real dirty price was 106.5244.
Like any bond, the present value of the future coupons and redemption amount will return the dirty price. “Linkers” are no different; real cash flows are present-valued at real yields to return the real dirty price.
One urban myth in relation to TIPS is that you will receive the annual year-on-year rate of inflation. This is not correct.
TIPS ensure that the purchasing power of the cash flows are maintained relative to their issue date. So if U.S. CPI is 9%, the investor does not receive 10.1875% at the next coupon date ([2.375% / 2] + 9%). To calculate the inflation uplift, we look back at the applicable value of the CPI in 2004 (187) and divide it into today’s equivalent value (289) to derive an “index ratio” of 1.55. This suggests over the period there has been inflation of about 55%. As a result, the investor’s coupon would be 1.840625 ([2.375 / 2] * 1.55). Think of the inflation uplift as being 55% of the coupon, rather than the coupon plus 55%.
Equally, an investor looking to buy the bond at these prices would need to pay the real dirty price of 106.5244 uplifted by the same index ratio of 1.55, which means a cash flow of $165.11 per $100 face value would be required.
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