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Chapter / Case 6

I-Bonds Adjust for Inflation

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Table of Content

What is Bond ?

Features of Bond.

Bond Market Players?

How are Bonds

traded?Bonds Types

Debt VS Equity

What is Inflation & Deflation?

Introduction of the Case.

Question & Answer.

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What is Bond? Bonds is simply a loan, but in

the form of security.

The issuer of the bond is the borrower and investors (bondholders) are the lenders.

Depending on the terms of the bond, it is obliged to pay interest (the coupon) at predetermined intervals and to repay the principal on the maturing date, ending the loan.

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Features of Bonds

Bonds have number of characteristics that play a role in determining the value of the bond. Principal Coupon Price Yield Maturity Credit Quality

Principal is the amount of money, the issuer will repay

the bondholder at the maturity of bond.

The coupon is the amount the bondholder will receive

as interest payments. Most bonds pay interest every 6 months, but it is possible for them to pay

monthly, quarterly or annually.

The price of the bond depends on 4 factors:

1. Market interest rates2. Credit quality

3. Maturity4. Supply demand

Yield of a bond is rate of return received from

investing in the bond, is based on the price paid for the bond and the coupon

payment.

The maturity date is the date in the future which the

investor’s principal will be repaid. There are 3 groups of

bond maturities:1. Short-term(bills) <1 year2. Medium-term(notes) 1

to 10 years3. Long-term(bonds) >10

years

The credit rating of a bond is important to investors as

it:1. Provides a standardized

measures of relative credit quality

2. Provides an impartial view of credit quality of

the issue.3. Allows the investor to

compare issues of similar credit quality.

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Bond Market Players

Bond Bond issuer Bond investors Bond dealers:

Intermediaries between bond issuers and investors Primary bond market:

New bonds only, issuer-to-investor Secondary bond market:

Previously issued bonds, investor-to-investor

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How are Bonds Traded?

Traditionally, bonds were purchased directly from the issuer, usually through an auction or a bank. Today, nearly all bonds are purchased electronically.

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Types of Bonds

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Types of Bonds

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Debt Instrument VS Equity Negatives of debt

instruments compared with equity assets is that once issued, fixed rate debt instruments cannot adjust for inflation.

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What is Inflation?

Inflation: Inflation is sustained increase in the general level of prices for

goods and services. It is measured as an annual percentage increase.

When inflation goes up, there is a decline in the purchasing power of money. 

Deflation: Deflation is when the general level of prices is falling. This is

the opposite of inflation.

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I-Bonds Adjust for Inflation

The US Treasury Department offers the I-bonds and first issued in 1998.

I-bond is an inflation-adjusted savings bond. Like all federal debt instruments, interest earnings are exempt

from state and local income taxes. I-bonds issued in denominations of $50 through $10,000.

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I-Bonds Adjust for Inflation

A series I-bond earns interest through the application of a composite rate.

The composite rate consists of :

The I-bond’s composite rate will be higher than its fixed rate if the

semiannual inflation rate reflects any

inflation.

Likewise I-bond’s composite rate will

be lower than its fixed rate if the

semiannual inflation rate reflects any deflation.

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Question

What effect do you think the inflation-adjusted interest rate has on the cost of an I-bond in comparison with similar bonds with no allowance for inflation?

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Answer

Regular Bond Consider a regular bond of $1,000

that offers a coupon rate of 5 percent. Each year, the bondholder would receive an income of $50 on the bond. At maturity, the bondholder would get back the $1,000 principal.

I-Bond Consider an inflation bond of

$1,000 that offers a coupon rate of 3 percent. In the first year, the bondholder would receive an income of $30. Assuming a 2 percent inflation rate, the value of the bond’s principal would rise to $1,020 in the second year, and the bondholder would receive an income of $30.60 in that year. This $30.60 reflects the 2-percent inflation adjustment.

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For your attention

Bonds should be considered only for long-term investments. Investments in government bonds are very low risk, stable

investments. If the investment goal is to invest long term with steady income, bond investment is a good option.

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