Understanding & Calculating Inflation Premium on Bonds

An inflation premium is the portion of bond yield that offsets inflation.

Over time, inflation eats away at the purchasing power of money. This is a big concern for the investor who may have money tied up in bonds for years. Inflation premium is the yield required to offset the expected inflation rate. You can calculate an estimate of the inflation premium based on market interest rates. Inflation premiums only measure inflation expectations. There's no way to be certain of actual future interest rates, especially several years ahead.

Seperating Yield Elements

The yield a bond pays can be viewed as a combination of three elements: the risk-free rate of return, an inflation premium and a credit risk premium. Calculating the inflation premium is a matter of separating this element from the others. Start by checking the current rates for Treasury bonds and Treasury Inflation-Protected Securities with the same maturity. Investors use the yields of these government securities to calculate inflation premiums, because they have virtually no credit risk, so you only need to separate the risk-free rate return from the inflation premium. The principal of TIPS bonds is adjusted for inflation, so the yield represents only the risk-free rate of return. Subtract the TIPS yield from the yield of the Treasury bond to find the inflation premium. For example, if the TIPS bond pays 2.5 percent and the Treasury bond pays 5.5 percent, the inflation premium is 3 percent.