What happens to TIPS when interest rates change? It depends on what’s driving the interest rate changes.
The nominal interest rate consists of three parts:
- real interest rate
- inflation expectation
- inflation risk premium
Real interest rate is what investors demands to earn after inflation. Inflation expectation is what they expect the inflation to be during the life of the bond. Because there is uncertainty to what the actual inflation will be versus the inflation expectation, nominal bond investors also earn a risk premium for taking that risk.
Inflation expectation and inflation risk premium are not directly observable separately. Taken together, they form the “break-even inflation rate.” If the nominal interest rate is 3% and the real interest rate is 1%, the break-even inflation rate is 3% – 1% = 2%.
The nominal value of a TIPS bond is driven by two factors:
- real interest rate
- actual inflation rate
To see how the value of a TIPS bond will change in response to interest rate changes, we have to see which part of the interest rate changes. Often more than one component would change and their effect would add to or offset one another.
I summarize the direction of changes in the table below. For the change in each component, I’m assuming the others don’t change (“all else being equal”). The fourth component, actual inflation rate, is not part of the nominal interest rate. I include it in the table because it affects the nominal value of a TIPS bond.
Nominal value is the value before adjusting for inflation. Real value is the value after adjusting for inflation.
|Nominal Value||Real Value||Nominal Value||Real Value|
|real interest rate UP||down||down||down||down|
|inflation expectation UP||down||down||no change||no change|
|inflation risk premium UP||down||down||no change||no change|
|actual inflation UP||no change||down||up||no change|
Please note these are only the immediate effects. When you reinvest bond interest payments after interest rates go up, you will be able to earn more interest on the reinvestment. If you hold the bond long enough, you are better off with a higher interest rate than a lower one.