In the context of TIPS and other inflation linked bonds, you'll often hear about the real yield. The real yield is essentially the return that investors receive above inflation. Unlike conventional bonds where the real yield can only be known in retrospect since future inflation is a uncertain, TIPS provide a real yield that's effectively locked in at the time of purchase. Let's dive into where this real yield comes from and how it's calculated. First, think of the real yield as the return you earn above future inflation. In practical terms for TIPS, future inflation can simply be assumed to be zero. Since any future changes in inflation will be exactly matched by an increase in the cash flows paid to TIPS investors equivalent to inflation being zero. The real yield on TIPS can be seen as a combination of the real risk-free rate and various risk premium, such as the term premium and liquidity premium. Since TIPS are US government bonds, they carry low credit risk, but investors may still demand compensation for locking in funds over longer terms term premium, and for potential challenges in trading TIPS due to lower market liquidity compared to nominal treasuries liquidity premium. These risk premium help explain why real yields often increase with bond maturity leading to an upward sloping real yield curve. So how is the real yield calculated? In essence, the real yield on a TIPS bond is derived using the same standard yield to maturity YTM formula that you'd apply to any bond. The calculation uses the bond's market price relative to its inflation adjusted principle, along with the fixed coupon payments. Let's look at a simple example. Imagine we have a TIPS with a market price of 98% of its inflation adjusted principle, which is currently 100%. The real yield calculation would use this price of 98% relative to the adjusted principle of 100% combined with the bonds fixed coupon payments. Since the bonds price is below its inflation adjusted principle, the real yield will be higher than the coupon rate.

This discount means that investors are effectively purchasing the bond at a lower price relative to its adjusted principle, securing a return that is consistently higher than future inflation over the entire life of the bond, whatever that future inflation level turns out to be.