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Adjusted bond

What Is an Adjusted Bond?

An adjusted bond is a type of debt security whose principal value, coupon payments, or both are modified over time based on specific, predefined criteria. These adjustments are typically designed to offer investors a form of risk protection against certain market conditions, most commonly inflation. Within the broader category of fixed income investments, adjusted bonds stand apart from conventional bonds, which usually pay a fixed coupon rate on a static principal amount until their maturity date. The most prominent example of an adjusted bond is a Treasury Inflation-Protected Security (TIPS), which ties its principal value to a measure of inflation.

History and Origin

The concept of an adjusted bond gained significant traction with the introduction of Treasury Inflation-Protected Securities (TIPS) in the United States. While the idea of linking bond payments to price indexes had been explored earlier, the U.S. Department of the Treasury first auctioned TIPS in January 1997. This move came after considerable market interest in an inflation-indexed asset class, providing investors with a direct hedge against rising prices. Before TIPS, investors seeking to protect their purchasing power from inflation had limited direct options within the bond market. The introduction of TIPS marked a significant development, offering a mechanism to ensure that the real return on an investment was preserved, even as the cost of living increased.4

Key Takeaways

  • An adjusted bond features dynamic principal or coupon payments tied to an external index, most commonly inflation.
  • Treasury Inflation-Protected Securities (TIPS) are the primary example of adjusted bonds in the U.S. market, indexing their principal to the Consumer Price Index (CPI).
  • These bonds aim to protect investors' purchasing power from the erosive effects of inflation.
  • The adjustments affect both the bond's principal value and its subsequent interest payments.
  • The ultimate payout at maturity date for an adjusted bond like TIPS is either the original or the inflation-adjusted principal, whichever is greater, offering principal protection.

Formula and Calculation

For an adjusted bond like TIPS, the primary adjustment occurs to its principal value, which then influences the semiannual interest payments. The adjustment is typically based on changes in the non-seasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U).

The formula for the adjusted principal at any given time ( t ) is:

Pt=P0×(CPItCPIoriginal)P_t = P_0 \times \left( \frac{\text{CPI}_t}{\text{CPI}_{\text{original}}} \right)

Where:

  • ( P_t ) = Adjusted Principal at time ( t )
  • ( P_0 ) = Original principal (par value) of the bond
  • ( \text{CPI}_t ) = Consumer Price Index at time ( t )
  • ( \text{CPI}_{\text{original}} ) = Consumer Price Index at the bond's issue date

The semiannual interest payment ((I_t)) is then calculated based on this adjusted principal:

It=Pt×Coupon Rate2I_t = P_t \times \frac{\text{Coupon Rate}}{2}

This means that as inflation rises, the bond's principal amount increases, leading to larger interest payments. Conversely, if deflation occurs, the principal (and thus interest payments) may decrease, though TIPS guarantee that the principal at maturity will not be less than the original par value.

Interpreting the Adjusted Bond

Interpreting an adjusted bond involves understanding its core mechanism: how its value and payments change in response to an external index. Unlike a conventional fixed income instrument where the coupon rate and principal remain static, an adjusted bond offers a dynamic yield profile. For TIPS, the adjusted principal directly translates into a changing stream of interest payments, providing a clearer picture of the bond's real return potential.

When evaluating an adjusted bond, investors should consider the current and projected outlook for the indexing factor. For example, with TIPS, expectations regarding future inflation are crucial. A rising CPI will increase the bond's principal, enhancing both the final payout and the interim interest payments. Conversely, a period of deflation would reduce the principal, though the original principal is protected at maturity date. This dynamic nature means that the effective yield to maturity can fluctuate, offering a distinct advantage during inflationary environments compared to traditional nominal bonds.

Hypothetical Example

Consider an investor purchasing a newly issued adjusted bond (specifically, a TIPS) with an original principal of $1,000 and a fixed coupon rate of 2%. On the issue date, the Consumer Price Index (CPI) is 250.

Six months later, the CPI has risen to 252.5. This represents an inflation adjustment of 1% (\left(\frac{252.5 - 250}{250} = 0.01\right)) for the six-month period.

  1. Calculate the adjusted principal:

    Pt=$1,000×(252.5250)=$1,000×1.01=$1,010P_t = \$1,000 \times \left( \frac{252.5}{250} \right) = \$1,000 \times 1.01 = \$1,010

    The bond's principal value has increased to $1,010.

  2. Calculate the semiannual interest payment:
    The interest payment is based on the adjusted principal:

    It=$1,010×0.022=$1,010×0.01=$10.10I_t = \$1,010 \times \frac{0.02}{2} = \$1,010 \times 0.01 = \$10.10

    In contrast, a traditional fixed-rate bond with a $1,000 principal and 2% coupon would have paid $10.00. The adjusted bond provides a higher interest payment because its principal has been adjusted upward due to inflation. This mechanism helps to preserve the investor's purchasing power.

Practical Applications

Adjusted bonds serve several critical roles in diversified investment portfolios and broader financial markets:

  • Inflation Hedging: The most direct application of an adjusted bond, particularly TIPS, is to provide a hedge against inflation. By linking their principal and interest payments to inflation indexes like the Consumer Price Index (CPI), these bonds help preserve an investor's purchasing power over time, making them attractive for long-term financial planning, such as retirement savings.
  • Portfolio Diversification: Incorporating adjusted bonds can enhance portfolio diversification. Their performance may be less correlated with traditional fixed income securities during periods of unexpected inflation, offering a distinct source of risk protection.
  • Monetary Policy Indicators: Central banks, such as the Federal Reserve, observe the yield differential between nominal Treasury securities and adjusted bonds (like TIPS) to gauge inflation expectations in the market. This "break-even inflation rate" provides valuable insights for setting monetary policy. For instance, the Federal Reserve utilizes open market operations to influence market conditions, and the pricing of adjusted bonds can offer feedback on the effectiveness of these operations.3
  • Capital Market Functioning Assessment: The dynamics of adjusted bonds can also provide insights into the overall health and liquidity of financial markets. For instance, the Federal Reserve Bank of New York maintains a Corporate Bond Market Distress Index (CMDI) which provides a unified measure of market conditions, and while not directly tied to TIPS, it reflects broader market liquidity which can impact all bond types, including adjusted ones.2

Limitations and Criticisms

While adjusted bonds offer significant benefits, particularly for inflation protection, they also have limitations and are subject to certain criticisms:

  • Deflation Risk: Although TIPS provide principal protection at maturity date (guaranteeing at least the original par value), periods of sustained deflation will cause the principal value to decline. While investors won't lose their original principal, their interest payments will decrease, and the bond's market value could fall below par, affecting liquidity if sold before maturity.
  • Taxation on Phantom Income: In many jurisdictions, the annual increase in the principal value of inflation-adjusted bonds, even if not received as cash, is taxable in the year it accrues. This "phantom income" can create a tax liability without a corresponding cash flow, requiring investors to have other funds available to pay taxes.
  • Lower Nominal Yield: Adjusted bonds typically offer a lower initial coupon rate compared to conventional nominal bonds of comparable maturity date. This is the trade-off for the embedded inflation protection. If inflation remains low or turns negative, the real return may not outperform traditional bonds.
  • Market Liquidity: While U.S. Treasury securities generally have high liquidity, the market for adjusted bonds can sometimes be less liquid than for highly traded nominal Treasury bonds. This might lead to wider bid-ask spreads, especially during times of market stress, making it slightly more challenging or costly to sell before maturity. Research has highlighted that illiquidity can significantly impact the yield spreads of corporate bonds, and similar, though less pronounced, effects can occur in less actively traded segments of the Treasury market.

Adjusted Bond vs. Treasury Inflation-Protected Security (TIPS)

The terms adjusted bond and Treasury Inflation-Protected Security (TIPS) are closely related, but their usage differs in scope.

An adjusted bond is a broader, descriptive term referring to any bond whose characteristics (such as principal or interest payments) change over its life based on a predefined metric. This adjustment mechanism is designed to protect investors from specific risks, most commonly inflation, but theoretically could be tied to other economic indicators or events.

A Treasury Inflation-Protected Security (TIPS) is a specific type of adjusted bond issued by the U.S. Department of the Treasury. TIPS are the most common and widely recognized example of an adjusted bond in the U.S. market. Their distinguishing feature is that their principal value is adjusted semiannually based on changes in the Consumer Price Index (CPI). The fixed coupon rate is then applied to this adjusted principal.

The confusion between the terms often arises because TIPS are the quintessential example of an adjusted bond. While all TIPS are adjusted bonds, not all adjusted bonds are necessarily TIPS. For instance, other types of bonds could have features that adjust, such as callable bonds where the issuer has the option to redeem the bond prior to its stated maturity date, which effectively "adjusts" its duration for the investor.1 However, when the term "adjusted bond" is used in the context of inflation protection, it almost always refers to the mechanism found in TIPS.

FAQs

What is the main purpose of an adjusted bond?

The main purpose of an adjusted bond, such as a Treasury Inflation-Protected Security (TIPS), is to protect investors' purchasing power from the eroding effects of inflation. It achieves this by periodically adjusting its principal value or coupon rate based on an inflation index.

How does an adjusted bond protect against inflation?

For inflation-adjusted bonds like TIPS, protection against inflation is achieved by linking the bond's principal value to a measure like the Consumer Price Index (CPI). When the CPI rises, the bond's principal increases, and subsequent interest payments (which are a fixed rate applied to the principal) also increase. This ensures that both the final payout and the interim income keep pace with rising prices.

Are all adjusted bonds issued by the government?

No, while Treasury Inflation-Protected Securities (TIPS) are the most common type of adjusted bond and are issued by the U.S. government, other entities can issue bonds with adjusting features. For example, some corporate bonds might have floating coupon rates tied to a benchmark interest rate, or they could have call provisions that allow the issuer to redeem them early, effectively adjusting the bond's term.

Can an adjusted bond lose money?

An adjusted bond can lose money if it is sold before its maturity date, especially if market interest rates rise or if deflation occurs, causing its market value to fall. While inflation-indexed adjusted bonds like TIPS protect your original principal at maturity (guaranteeing at least the par value), their market price can fluctuate daily. Additionally, the real return may be low or negative if the initial yield is very low and inflation does not materialize as expected.

How do I know if a bond is an adjusted bond?

Information about whether a bond is an adjusted bond, and specifically what mechanism it uses for adjustment (e.g., inflation indexing, floating rate, call features), will be detailed in the bond's prospectus or offering documents. Investors can obtain these documents from their investment professional or through regulatory filings, especially for publicly offered Treasury securities or corporate bonds.