Adjusted coupon

What Is Adjusted Coupon?

An adjusted coupon refers to the interest payment received on an inflation-indexed bond, such as Treasury Inflation-Protected Securities (TIPS). Unlike traditional bonds where the coupon rate is applied to a fixed principal amount, the adjusted coupon is calculated on a principal amount that fluctuates with inflation or deflation. This mechanism within fixed income securities ensures that the investor's purchasing power is preserved over time, as the actual interest received reflects changes in the cost of living.

History and Origin

The concept of linking debt payments to a price index to protect against the erosion of value due to inflation has historical roots. The first known inflation-indexed bonds were issued by the Commonwealth of Massachusetts in 1780 during the American Revolutionary War to address severe wartime inflation and the declining purchasing power of soldiers' pay.⁷ While the concept was largely forgotten after this initial period, it re-emerged in various forms in the 20th century.

Modern inflation-indexed bonds gained significant traction when the United Kingdom began issuing inflation-linked Gilts in 1981. The United States introduced Treasury Inflation-Protected Securities (TIPS) in January 1997, marking a pivotal moment for these instruments in a major developed market.⁶ The U.S. Treasury created TIPS to offer investors a direct hedge against inflation, with their principal value designed to adjust based on the Consumer Price Index (CPI).⁵

Key Takeaways

• The adjusted coupon is the interest payment on inflation-indexed bonds, calculated on an inflation-adjusted principal.
• It aims to preserve investors' purchasing power by accounting for changes in inflation.
• When inflation rises, the principal increases, leading to larger adjusted coupon payments.
• During deflation, the principal may decrease, resulting in smaller adjusted coupon payments, though typically protected against falling below the original par value at maturity.
• Adjusted coupons provide a real return by offsetting the effects of inflation on bond income.

Formula and Calculation

The calculation of the adjusted coupon involves two primary components: the fixed stated coupon rate and the inflation-adjusted principal amount.

The principal value of an inflation-indexed bond is regularly adjusted by an index ratio. This ratio is typically derived from changes in a specific inflation measure, such as the Consumer Price Index (CPI).

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

Where:

• Original Principal = The par value of the bond at issuance (e.g., $1,000).
• Index Ratio = Current CPI / Base CPI (CPI on the issue date of the bond).

The adjusted coupon payment is then calculated semi-annually (or as per the bond's payment schedule) based on this adjusted principal:

For example, if a TIPS bond has a 1% coupon rate and its original principal of $1,000 has been adjusted by inflation to $1,050, the semi-annual adjusted coupon payment would be:

Interpreting the Adjusted Coupon

The adjusted coupon is a dynamic measure of income from an inflation-indexed bond, reflecting the ongoing impact of inflation on the bond's value. When analyzing an adjusted coupon, it is crucial to understand that its variability is a feature, not a flaw. A rising adjusted coupon indicates that the underlying principal has increased due to inflation, thereby preserving the investor's purchasing power. Conversely, a declining adjusted coupon (or smaller increase) reflects lower inflation or even deflation, which would lead to a smaller principal adjustment.

The significance of the adjusted coupon lies in its ability to provide a more accurate picture of an investor's real return compared to conventional bonds. While the stated coupon rate remains constant, the actual interest payments change, ensuring that the income stream maintains its real value against rising prices.

Hypothetical Example

Consider an investor who purchases a 10-year Treasury Inflation-Protected Security (TIPS) with an original principal of $1,000 and a fixed coupon rate of 0.50%. The bond pays interest semi-annually.

Year 1, First Half (Inflation):
Assume the Consumer Price Index (CPI) increases by 2% annually, translating to a 1% increase over six months.

• Original Principal: $1,000
• Inflation Adjustment: $1,000 * 1.01 = $1,010
• Adjusted Principal: $1,010
• Adjusted Coupon Payment: (0.0050 / 2) * $1,010 = $2.525

Year 1, Second Half (Continued Inflation):
Suppose CPI increases by another 1.5% in the next six months (total 3.5% for the year from original issuance).

• Adjusted Principal from previous period: $1,010
• New Inflation Adjustment: $1,010 * 1.015 = $1,025.15
• Adjusted Principal: $1,025.15
• Adjusted Coupon Payment: (0.0050 / 2) * $1,025.15 = $2.563

This example demonstrates how the adjusted coupon automatically increases as the bond's principal value is indexed to inflation, ensuring that the interest payments maintain their real value.

Practical Applications

Adjusted coupons are primarily relevant in the context of inflation-indexed fixed income securities, such as Treasury Inflation-Protected Securities (TIPS). These bonds are a key tool for investors seeking to protect their portfolio against the eroding effects of inflation.

• Inflation Hedging: The most direct application is hedging against inflation. As the CPI rises, the bond's principal adjusts upwards, leading to higher interest payments via the adjusted coupon. This helps preserve the investor's purchasing power over time.
• Retirement Planning: Individuals planning for retirement often use inflation-indexed bonds to ensure their future income streams can keep pace with rising living costs, providing a predictable real income.
• Institutional Investing: Large institutional investors, such as pension funds and endowments, incorporate these bonds into their asset allocations to manage inflation risk and meet long-term liabilities.
• Real Return Measurement: The adjusted coupon facilitates the calculation and understanding of a bond's real return, which is the return after accounting for inflation.

An explanation of how TIPS work illustrates the practical application of the adjusted coupon in the market.⁴

Limitations and Criticisms

While the adjusted coupon mechanism provides crucial inflation protection, there are certain limitations and criticisms associated with it.

One notable aspect is the "phantom income" issue. For U.S. TIPS, the annual increase in the bond's principal due to inflation is considered taxable income by the Internal Revenue Service (IRS) in the year it accrues, even though the investor does not receive this principal adjustment until maturity or sale.³ This can create a tax liability without a corresponding cash flow to cover it, leading to a liquidity concern for some investors. Investors should consult IRS guidance on bond taxation to understand these implications.

Another consideration is that in periods of deflation, the adjusted principal can decrease, leading to smaller adjusted coupon payments. While the U.S. Treasury guarantees that the bond will mature at no less than its original par value, the interim coupon payments will be reduced if deflation occurs. This can affect the bond's short-term income stream and overall yield if held for income generation. Furthermore, inflation-indexed bonds typically offer lower stated coupon rates compared to conventional bonds during periods of low inflation expectations.²

Adjusted Coupon vs. Nominal Coupon

The key distinction between an adjusted coupon and a nominal coupon lies in their underlying principal.

The nominal coupon represents a fixed percentage of a bond's original face value, providing a predictable but inflation-vulnerable stream of interest payments. In contrast, the adjusted coupon adapts to economic conditions, specifically inflation, ensuring that the investor's income maintains its purchasing power. This adjustment makes inflation-indexed bonds a distinct asset class for investors focused on real returns.

FAQs

What does "adjusted" mean in adjusted coupon?

"Adjusted" refers to the fact that the bond's underlying principal amount, on which the coupon payment is calculated, is regularly changed to account for inflation or deflation, typically based on the Consumer Price Index (CPI).

How often does the adjusted coupon change?

The adjusted coupon changes with each interest payment, usually semi-annually, because the bond's principal value is typically adjusted daily or monthly in line with inflation indices. This adjustment influences the dollar amount of the coupon payment received.

Are all bonds eligible for an adjusted coupon?

No, only inflation-indexed bonds, such as Treasury Inflation-Protected Securities (TIPS), feature an adjusted coupon. Conventional bonds pay a fixed nominal coupon based on their original face value.

Does a falling adjusted coupon mean the bond is losing value?

Not necessarily. A falling adjusted coupon usually indicates a period of lower inflation or deflation. While the actual dollar amount of the payment decreases, the bond's primary function is to preserve real purchasing power, and the reduced payment reflects the lower rate of price increases.

Is the adjusted coupon guaranteed?

The fixed coupon rate of the bond is guaranteed, but the dollar amount of the adjusted coupon payment is not fixed because it depends on the fluctuating principal. The principal itself is protected against deflation below its original par value at maturity for U.S. TIPS.¹