THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 111

CHAPTER 4

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.