Inflation Protected Securities Definition
In trading parlance, Inflation Protection is the adjustment of value in the price of securities, with respect to inflation. Prices of securities, their payouts, and dividends, are adjusted periodically in keeping with the rate of inflation. Inflation is the rise of prices for goods and services.
For e.g., A health insurance contract that carries a price adjustment clause in case of an increase in the prices of medical services.
A Little More on What are Inflation Protected Investments
Inflation Protection mitigates the risk of inflation on an investment portfolio by diversifying it. Common instances of Inflation Protection are:
Treasury Inflation Protected Securities (TIPS)
Treasury Inflation Protected Securities – TIPS – are securities adjusted for inflation. The price value of the security is adjusted in the Consumer Price Index with respect to fluctuating inflation rates, while the interest on it remains fixed on the treasury. This makes Inflation Protected Securities available at very low risk factor as well as low interest rates in the bonds market.
TIPS perform well during rise in inflation. Conversely, ROI on TIPS is low if there’s no rise in inflation during the lifetime of these securities. They also require tax adjustments in accordance with the adjustments made due to inflation.
Inflation Protected Commodities
Some Commodities like gold are used to hedge against inflation as the price of commodities is directly proportional to inflation. Returns on Inflation Protected Commodities are better than TIPS, as TIPS tend to have a lower interest rate. The downside to this is that Commodities carry the risk of reduced production and regional output. Other factors may also influence the sensitivity of commodities overtime to inflation. An alternative way of hedging against inflation in commodities’ prices is to invest in stock options of companies that produce these commodities.
References for Inflation Protection
Academic Research on Inflation Protection
- Pricing treasury inflation protected securities and related derivatives using an HJM model, Jarrow, R., & Yildirim, Y. (2003). Journal of Financial and Quantitative Analysis, 38(2), 337-358. This paper illustrates the validity of the HJM model in pricing TIPS and other derivative securities in the U.S. stock markets, by analysing its hedging performance.
- Diversification Benefits of Treasury inflation protected securities: an empirical puzzle, Mamun, A., & Visaltanachoti, N. (2006). This paper analyses empirical data in the U.K. stock markets, to gauge the value of TIPS to investors, their effect on portfolio diversification, and vulnerability to inflation, with conclusion drawn in their favour.
- Inflation or disinflation? Evidence from maturing US Treasury inflation–protected securities, Chu, Q. C., Pittman, D. N., & Chen, J. H. (2007). Applied Economics, 39(3), 361-372. This article studies data on TIPS for a 6 month period and tests whether maturing TIPS prices can be used to reasonably forecast inflation rates and provide timely feedback to the open markets.
- Are Treasury inflation protected securities really tax disadvantaged?, Hein, S. E., & Mercer, J. M. (2006). Journal of Financial Research, 29(4), 575-592. This article addresses the critical questions raised about tax disadvantages of TIPS. It uses empirical data to conclude that TIPS generally give better after-tax returns than conventional securities.
- The US Treasury’s Inflation–Protected Securities (TIPS): market reactions and policy effects, DePrince Jr, A. E., & Ford, W. F. (1998). Business Economics, 47-53. This paper takes a look at the journey of TIPS since their introduction, buyers response, market reaction, and the measures taken by IRS to promote them.
- Treasury inflation protected securities: New Perspectives on their significance to portfolios, D’Vari, R., & Chugh, L. C. (2003). The Journal of Business and Economic Studies, 9(1), 1. This journal presents a new perspective on the importance of TIPS in diversifying portfolios. It offers a framework distinct from assets allocation, and the risk and rewards of TIPS returns, under different economic conditions like inflation and growth.
- Series I Savings Bonds Announcement Effects on Treasury Inflation–Protected Securities, Taylor, D. A., & Campus, B. (2009). This paper studies the effect of Series I savings bonds on TIPS. Event study methodology was employed by the author to examine yield movements before and after the announcement of Series I Savings Bonds on the market performance of TIPS.
- On the Performance Drivers of US Treasury Inflation–Protected Securities., Xu, X. E. (2011). International Review of Accounting, Banking & Finance, 3(4). This paper studies and compares data provided by Barclays Capital for an eleven year period, on the performance of U.S. TIPS vs. Non conventional Treasuries. Empirical results drawn through Structural vector autoregressive model are discussed in detail.
- Assessing the term structure of expected inflation using treasury inflation—protected securities: near real-time measures for those who need quick estimates, DePrince Jr, A. E. (2003). Business Economics, 38(1), 46-55.
- Treasury Inflation–Protected Securities, Chu, Q. C., & Pittman, D. N. (2013). In Encyclopedia of Finance (pp. 257-262). Springer, Boston, MA. This paper discusses the unique role and characteristics of TIPS in diversifying portfolios, information aggregation in forecasting inflation rates, and their term structure.
- Can Risk Models Extract Inflation Expectations from Financial Market Data? Evidence from the Inflation Protected Securities of Six Countries, Tortorice, D. L., & Kita, A. (2018). This paper studies the TIPS performance data of six countries and examines the accuracy of their inflation expectation forecasts. Conclusions vary for eurozone but other nations can rely on these forecasts with reasonable accuracy to inform policy making.