The Personal section of today's Wall Street Journal discusses how to invest to beat inflation, other than buying very rich TIPs. One suggestion offered by the Journal are Corporate inflation adjusted notes (IPIs). The Journal does a fairly good job of explaining IPIs. Noted are IPI's illiquidity and credit risk. However, the Journal could have been clearer in explaing the inflation adjustment feature.
The Journal states that IPIs adjust using the year-over-year change of CPI as a benchmark. This is not exactly true. IT is not CPI, but the CPI Urban Consumer Index Non-Seasonably Adjusted or CPURNSA as a benchmark. This may sound nit-picky as they are similar inflation measures, but similar is not exact.
Here is the formula to derive the inflation component of an IPI's coupon.
It is the current month CPURNSA (usually a three month look back, so the bond is always lagging current data) minus a year ago CPURNSA divided by a year ago CPURNSA. This can be expressed as CPI1 - CPI13 / CPI13.
If one thinks about this for a minute one comes to a possibly troubling conclusion. That is, it is possible for inflation to be positive and have the coupon decline. This is possible if the year-over-year change, though positive, is less than the previous coupon. If the inflation rate was unchanged, ones coupon would consist only of the spread above CPURNSA. If we have deflation, the coupon can be as low as 0.00%. This, plus the fact that IPIs are small illiquid issues make them very poor bid for in the corporate bond market. It is not uncommon for a bond purchased at par one day to be bid at 92 the very next day. IPIs are buy and hold securities.
IPIs should be used as a part of a well-constructed fixed income portfolio as a hedge versus inflation and not as a way to make a quick buck. This may be especially true since we may be at the top of the inflation cycle.
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