Do nominal bonds also protect you from inflation? Yes and no. Nominal bonds offer protection for expected inflation, while TIPS offer protection for unexpected inflation.
The investment return on a nominal bond comes from the interest payments and the interest rate changes. As long as the interest rate on a nominal bond is higher than the rate of inflation and the interest rate didn’t go up dramatically which lowered the bond’s price, your money’s purchasing power is preserved. If the inflation rate or the interest rate shoots up, which often happens at the same time, the nominal bond will not preserve the purchasing power.
The investment return on TIPS comes from three parts: the real interest rate, the inflation adjustment, and the real interest rate changes. If the actual CPI changes come in lower than expected, the return from TIPS will be lower as well. In such cases, all else being equal, nominal bonds will do better than TIPS. However, if inflation is higher than expected, nominal bonds will do worse than TIPS. For this reason, TIPS are said to offer protection for unexpected inflation, while nominal bonds offer protection for expected inflation.
The following table shows the cash flows of a 10-year regular Treasury bond with a 5% interest rate and a 10-year TIPS with a 2% interest rate when inflation is 3% per year over 10 years. A negative number represents cash outflow, i.e. money going out of your pocket, while a positive number represents cash inflow, i.e. money coming into your pocket.
|In Nominal Dollars||In Today’s Dollars|
|Year||Nominal Bond||TIPS||Nominal Bond||TIPS|
|10||Principal + Interest||1,050.00||1,370.79||781.30||1,020.00|
|Rate of Return||5%||5%||2%||2%|
In this example the nominal bond and the TIPS bond have the same investment return but the cash flows are different. The nominal bond pays more interest, steady in nominal dollars, but declining in today’s dollars. The nominal bond’s final payoff value is lower because part of the return is already paid out via higher interest payments. The TIPS bond pays lower interest, increasing in nominal dollars, but steady in today’s dollars. The final payout is higher. In a sense, part of the interest from the TIPS bond is automatically reinvested and postponed until the bond matures. If part of the interest from the nominal bond is also reinvested, the cash flows will be similar.
However, the rates of return on these two bonds will be different if the inflation rate is not 3%. The following chart shows the nominal returns under different inflation rates.
In terms of nominal returns, the nominal bond’s return holds steady while the TIPS’ return goes up with inflation. The following chart shows the real returns under different inflation rates.
In terms of real returns, the nominal bond’s return declines with inflation while the TIPS’ return holds steady.