THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 111

CHAPTER Understanding Interest Rates 79 Formerly, real interest rates in Canada were not observable; only nominal rates were reported This all changed on December 10, 1991, when the government of Canada began to issue indexed bonds, whose interest and principal payments are adjusted for changes in the price level (see the FYI box With Real Return Bonds, Real Interest Rates Have Become Observable in Canada) FYI With Real Return Bonds, Real Interest Rates Have Become Observable in Canada On December 10, 1991, the Canadian government issued coupon bonds whose coupon payment and face value are indexed to the Consumer Price Index (CPI) These securities are known as Real Return Bonds and are designed to provide investors with a known real return if held to maturity Other countries such as the United Kingdom, Australia, and Sweden also issue similar indexed securities, and the U.S Treasury joined the group (in September 1998) by issuing TIPS (Treasury Inflation Protection Securities) These indexed securities have successfully acquired a niche in the bond market, enabling governments to raise more funds In addition, because their interest and principal payments are adjusted for changes in the price level, the interest rate on these bonds provides a direct measure of a real interest rate These indexed A PP LI CATI O N bonds are very useful to policymakers, especially monetary policymakers, because by subtracting their interest rate from a nominal interest rate on a nonindexed bond, they generate more insight into expected inflation, a valuable piece of information For example, on January 28, 2009, the interest rate on long-term Canada bonds was 3.72%, while that on the long-term Real Return Bond was 2.26% Thus, the implied expected inflation rate, derived from the difference between these two rates, was 1.46% The private sector finds the information provided by Real Return Bonds very useful: Many financial institutions routinely publish the expected Canadian inflation rate derived from these bonds Calculating the Principal and Coupon Payment of Real Return Bonds Consider a real return bond with a face value of $1000 and a coupon yield of 2% Calculate the principal and coupon payment after one year if the inflation rate is 3% Solution After a year, to account for inflation, the principal will be increased by 3%, from $1000 to $1030 The coupon yield is still 2%, but applies to the new principal of $1030, instead of $1000 Hence, the coupon payment will be 0.02 * $1030 + $20.60