At a recent NCUA listening session in Alexandria, Va., representatives from the agency were asked whether investment regulations might be broadened to allow credit unions to purchase Treasury Inflation Protected Securities. Interest in these securities among institutional investors is quite high these days as many view the Fed's easy money policy as a precursor to future inflation. The TIPS market has some peculiarities that are important to keep in mind as credit unions prepare for this potential expanded authority.

TIPS are essentially regular fixed-rate bonds where the principal amount increases over time in conjunction with the Consumer Price Index. Each TIPS issue has a "reference CPI" based on its original issue date. Comparing today's CPI with the reference CPI produces an "index ratio" that governs the current principal amount and periodic interest payments. For example, an investor buys $1 million of a five-year TIPS issue where the reference CPI at issuance was 200. (For CPI, the average price level from 1982-1984 equals 100.) At maturity, CPI has increased to 230, making the index ratio 1.15 (230/200) and meaning the investor will receive $1.15 million in principal. Similarly, each periodic interest payment is a function of the coupon rate, the original principal amount and the index ratio at the time of the interest calculation, meaning coupon payments will generally increase over time in conjunction with CPI gains.

One great benefit of an active TIPS market is that investors can readily gauge the market's inflation expectations. By comparing the yield on a TIPS issue to the yield on a regular Treasury bond with the same maturity, one can infer the implied inflation rate over the life of the bond. For example, the current five-year TIPS issue maturing on April 15, 2017, has a yield around negative 1.05%. A Treasury bond with a similar maturity, the April 2017 five-year note yields 0.75%. The difference between these two yields, 1.80%, is the "break even" inflation rate for the five-year TIPS. If inflation runs above 1.80% over the next five years, the realized yield on the TIPS will exceed that of the regular bond. If inflation is less than 1.80% over this period, an investor would have been better off buying the regular bond.