78106_05_Web_Ch05B_p01-02

78106_05_Web_Ch05B_p01-02 - WEB EXTENSION 5B A Closer Look...

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WEB EXTENSION 5B A Closer Look at TIPS: Treasury Inflation- Protected Securities I nvestors who purchase bonds must constantly worry about inflation. If inflation turns out to be greater than expected, bonds will provide a lower than expected real return. To protect themselves against expected increases in inflation, investors build an infla- tion risk premium into their required rate of return. This raises borrowers costs. In order to provide investors with an inflation-protected bond, and possibly to reduce the cost of debt to the government, on January 29, 1997, the U.S. Treasury issued $7 billion of 10-year inflation-indexed bonds called Treasury Inflation- Protected Securities (TIPS). Since then, the Treasury has continued to offer TIPS with original maturities up to 30 years. To see how TIPS work, let s take a closer look at the TIPS that were auctioned on April 7, 1999. These TIPS mature on April 15, 2029, and pay interest on April 15 and October 15 of each year. The bonds have a fixed coupon rate of 3.875%, but they pay interest on a principal amount that increases with inflation. At the end of each 6-month period, the principal (originally set at par, or $1,000) is adjusted by the inflation rate. For example, on April 15, 1999, the Reference CPI (as defined by the U.S. Treasury) was 164.39333. At the time of the
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78106_05_Web_Ch05B_p01-02 - WEB EXTENSION 5B A Closer Look...

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