Hoping you can help clarify something for me.
When we are calculating the nominal return for a IPS question, we add the inflation component. However when we are assigning asset allocation to a pension fund, we assign nominal bonds to asset not linked to inflation…
I’m struggling to understand the logic…
Why do we does nominal = real + inflation, but we use nominal bonds when there is NO inflation indexation in a pension plan?
thanks
S2000 can confirm if what I am saying is true.
Nominal Rate = Real Rate + inflation -> what we do on the IPS questions.
Pension fund - liability mimicking asset portion
Nominal Bond -> Pays the “assigned” rate of interest (coupon) on the bond.
Real Bond -> pays the assigned real rate of interest (coupon) on the bond + pays the inflation index component as well.
Thanks for your response.
TIPS are real rate bonds and offer coup + inflation. In the liability mimicking instance a real rate bond implies that the inflation component is already incorporated into the returns. However when we do an IPS question the real rate is without inflation…
I dont see why they are different.
you are interested in the REAL RATE for IPS, REAL RATE Bond for the Mimicking part.
The REAL RATE - does not include inflation. The real rate BOND does include inflation.
I’m also curious.
Financial instrument: Real means included inflation
Return: Real means excluded inflation
Interesting …
Nominal always means that inflation is included, and real always meas that inflation is not included.
The confusion is in the misunderstanding of how those terms are applied to bonds: they describe the bonds’ coupon rates.
To describe a bond as nominal means that its coupon rate includes a premium for (expected) inflation.
To describe a bond as real means that its coupon rate does not include a premium for inflation; inflation is handled in the face value of the bond.
With liabilities.
You work out the endownment needs a 4% return to pay staff wages and costs. This is in 2023 terms.
As we move through time inflation will mean wages and other costs will increase by inflation.
I am planning my retirement. In today’s terms I know how much money I want a year but I have to think in 20 years the price of food will be higher.
So I now I need a 4% return but I need to add inflation to this in order to get the return I require to protect the purchasing power of my future income. Say inflation 2%
So I have real return objective of 4% and a nominal objective of 6% (or 6.08%)
Bonds
If a bond offers a “real return” of 4% it is above the underlying inflation rate. UK has inlation linked bonds that quote a real coupon rate.
Most bonds quote a nominal rate - the cash you will actually get - (rational) investors will have determined the rate of return they want on the bonds including a premium for inflation.