Investments, tenth edition

  Indexed Bonds   

Indexed bonds make payments that are tied to a general price index 

or the price of a particular commodity. For example, Mexico has issued bonds with pay-

ments that depend on the price of oil. Some bonds are indexed to the general price level. 

The United States Treasury started issuing such inflation-indexed bonds in January 1997. 

They are called Treasury Inflation Protected Securities (TIPS). By tying the par value of 

the bond to the general level of prices, coupon payments as well as the final repayment of 

par value on these bonds increase in direct proportion to the Consumer Price Index. There-

fore, the interest rate on these bonds is a risk-free real rate. 

 To illustrate how TIPS work, consider a newly issued bond with a 3-year maturity, par 

value of $1,000, and a coupon rate of 4%. For simplicity, we will assume the bond makes 

annual coupon payments. Assume that inflation turns out to be 2%, 3%, and 1% in the 

next 3 years.  Table 14.1  shows how the bond cash flows will be calculated. The first pay-

ment comes at the end of the first year, at  t   5  1. Because inflation over the year was 2%, 

the par value of the bond increases from $1,000 to $1,020; because the coupon rate is 4%, 

the coupon payment is 4% of this amount, or $40.80. Notice that par value increases by the 

inflation rate, and because the coupon payments are 4% of par, they too increase in propor-

tion to the general price level. Therefore, the cash flows paid by the bond are fixed in  real  

terms. When the bond matures, the investor receives a final coupon payment of $42.44 plus 

the (price-level-indexed) repayment of principal, $1,061.11.  

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