This year the U.S. Treasury began offering inflation-indexed bonds. How do these bonds differ from conventional bonds?
Conventional, or nominal, bonds repay investors principal plus some stated interest; indexed bonds repay principal adjusted for inflation and a fixed interest rate applied to the adjusted principal. The Treasury calculates semi-annual interest payments on its indexed 10-year notes by adjusting the principal for inflation according to the Consumer Price Index (CPI)
What's the attraction of inflation-indexed bonds?
For investors, the major benefit is the guarantee of a real yield. In contrast, conventional bonds use nominal interest rates, composed of the real interest rate plus the expected inflation rate. Thus, if an investor purchases a bond with a 7 percent nominal interest rate and inflation is expected to be 3 percent, the real yield would be 4 percent. If, however, the actual inflation rate turns out to be 4 percent, the investor's real yield has fallen to 3 percent. To compensate investors for assuming such risk, an inflation risk premium is built into nominal bond yields—estimated to be at least 50 basis points, or 1/2 percent, for short-term bonds and even more for longer-term bonds.
An advantage of inflation-indexed bonds for the issuer is that it does not have to pay the inflation risk premium since inflation risk has been eliminated.
What are the negative features of indexed bonds?
For investors, the tax treatment and the real rate of return when compared with alternative investments can be unattractive. The tax consequences are twofold: First, because the U.S. tax code does not distinguish between increases in real income and increases in nominal income due to inflation, the indexed bondholder's tax liabilities will increase, lowering the after-tax real yield. Second, investors will pay taxes on the inflation-adjusted increase in principal accrued each year (as well as interest received), even though it is not paid out until maturity. This tax treatment can neutralize the primary incentive of indexed bonds—that of protection from inflation.
The yield on indexed bonds may also be a disincentive for investors. Even after adjusting for inflation and risk, historic yields over the long term on stocks and many corporate bonds outperforms the yields on less risky indexed bonds.