Quote:
Originally Posted by lukeh
I must be missing something...
Why is the price of the bond moving so much if the coupon is moving at the same time? Is it not true that the interest rate on TIPS bought 4 years ago will be the same as what TIPS are currently being issued at? I mean if all the TIPS are following the same inflation index shouldn't they all be paying the same interst rate no matter when they were issued?
What am I missing?
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Not sure what you are missing, but here is my rationale:
The price you
should pay for a bond is the expected future payments, discounted by corresponding interest rates for those terms.
With a regular bond the payments are known with certainty, so we simply discount the future coupon and principal payments by rates found on the yield curve.
With a TIPS, you have to make an assumption about what inflation is going to be over the life of the bond. Using that assumption, you can figure out what your payments will be, and discount those payments the same way as you did with an ordinary treasury bond. With this in mind, if we look at pricing on TIPS, we can see what "the market" believes future inflation will be by comparing them to nominal Treasuries.
If you go and buy a TIPS, and inflation behaves exactly as as "the market" expects, you won't make much more money than if you had simply bought a normal treasury bond (think about it... otherwise you could simply short a nominal bond, and use the proceeds to buy a TIPS, and be guaranteed free money as the coupons on the TIPS were gradually re-indexed higher)
The way you make money on a TIPS (over and above the money earned on a nominal bond) is if inflation turns out to be higher than the market expected when you bought the bond.
Does that make sense?