The Effect of Inflation on U.S. Treasury Notes

Inflation Defined

Inflation is the rate at which prices for goods and services rise. It is measured as an annual percentage increase. This means that purchasing power subsequently falls. Inflation is most often measured in conjunction with a price index, the Consumer Price Index being the most well known. The Consumer Price Index measures the changes in price level of goods and services, and the annual percentage change is used as a measure of inflation.

Treasury notes are intermediate term bonds issued by the United States Treasury. Treasury notes pay investors semiannually at a fixed interest rate. Treasury notes are used to help fund shortfalls in the federal budget and are backed by the United States government. Because they are government backed, Treasury notes are considered to be the safest investments due to the fact that default by the government is highly unlikely. Low risk and a high level of liquidity cause Treasury notes to be among the lowest yielding bonds.

Inflation's effects on investments is a big concern for many investors, especially those who own fixed income investments. Treasury notes are often the hardest hit by inflation. These notes pay a fixed rate of return, and if inflation increases faster than the return, they become less valuable. The loss in value can spur investors to sell, further depreciating the value and causing the Treasury to increase the interest rate in order to sell the securities. Inflation decreases purchasing power, thereby decreasing the real return on the note. The real rate of return on a Treasury note is the growth of the purchasing power, not the return on the money invested. An easy way to calculate it is to subtract the current inflation rate from the interest rate the note is paying. Since Treasury notes tend to pay low interest rates, inflation can make the notes real return almost nothing. This can have a tremendous impact on investors' purchasing power.

The government issues Treasury Inflation Protected Securities more commonly know as TIPS. These are simply another type of Treasury note and are quite popular among investors due to their inflation protection. These notes are indexed to inflation in order to protect investors from the negative effects inflation can have on regular Treasury notes. These notes are considered to be low-risk investments because their par value rises with inflation as measured by the aforementioned Consumer Price Index. The interest rate remains fixed on these securities, but the increase in par value helps to prevent a significant decrease in purchasing power, thereby keeping the real rate of return in line with the interest rate.