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Bloopers & Blunders: Yield on Inflation-Indexed Bonds

Quotation

"The Treasury auctioned $7 billion in 10-year inflation-indexed notes at an annualized fixed yield of 3.449%, and by the end of trading the yield was down to 3.38%--a further indication of the robust demand for the securities." (LA Times, January 30, 1997)

Analysis

The quotation seems to attribute the drop in yield to "the robust demand for the securities." But this would be true only if all other factors influencing a bond’s yield did not change. One way to analyze the issue is to remember that:

yield on a bond = yield on a similar maturity Treasury bond + a risk premium to compensate for the risk inherent in the bond in question.

Now suppose that at the same time the yield on a 10-year Treasury note dropped by 0.069%. What should happen to the yield on a 10-year bond? It should drop by exactly 0.069%.

Thus, it is clear that the drop in the yield of the inflation-indexed notes could have been due to a drop in the yield on the 10-year Treasury.