A Framework for Valuing Treasury Inflation‐Protected Securities

Abstract

Treasury inflation-protected securities (TIPS) offer investors near-complete protection against inflation risk because both their coupon and principal payments are adjusted for realized inflation. Investors in nominal Treasury bonds demand compensation not only for expected inflation but also for the uncertainty surrounding inflation expectations, referred to as the inflation risk premium. Inflation expectations implied by the market can be deduced by comparing the yields of nominal Treasury bonds with the yields of similar-maturity TIPS. However, the difference in yields between nominal bonds and TIPS, known as the breakeven spread, needs to be adjusted for: the inflation risk premium; the difference in convexity value between nominal and TIPS; and the liquidity premium of nominal Treasuries. Keywords: Treasury bonds; Treasury inflation-protected securities (TIPS); convexity; risk premium; inflation expectations