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I'm trying to understand yield to maturity of treasury bonds.

For example, I have a 20 year inflation linked treasury bond which pays a inflation linked spread over a given fixed rate, and a 20 year fixed rate treasury bond which matures on the exact same day. The YTM on the bonds are different.

What does this difference in YTM represent to investors?

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@AlexC has already provided the correct answer, but I thought I'd provide a bit more details.

The breakeven inflation (still the mostly widely used practitioner terminology) is defined as follows: $$ \text{breakeven inflation} = \text{nominal yield} - \text{TIPS yield}. $$ It is called the breakeven inflation ("BEI") because if ex-post realized inflation is identical to the ex-ante BEI, then an investor should be indifferent between investing in TIPS and buying the nominal comparator (both would generate the same returns).

As @AlexC mentioned, TIPS breakeven is closely linked to inflation expectation, but in reality, it is a highly noisy measure of the former. TIPS are much less liquid compared to nominal Treasuries, so investors typically require a HIGHER yield to compensate for the illiquidity risk. Of course, this makes breakeven inflation LOWER than the true inflation expectation. This was a huge problem during the early years of the TIPS program (investors were not familiar with TIPS) and during the 2008 financial crisis. The chart below plots 10-year breakeven inflation against a market-based measure of 10-year inflation expectation:

TIPS breakeven vs inflation expectation

As you can see, during the depth of the financial crisis, 10-year TIPS breakeven traded down to 0, but surely no one expected inflation to average 0% over the next 10-years! At the time, TIPS became so illiquid that their yields are substantially inflated.

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  • $\begingroup$ Would inflation linked swap rates of similar tenor be expected to line up with breakeven inflation on respective tenor treasuries? $\endgroup$ – Ben Apr 2 '16 at 23:32
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    $\begingroup$ @Ben No, inflation swap rates are typically higher than TIPS breakeven. The reason is quite technical, but boils down to 1) supply/demand; 2) funding differences; 3) par floor value embedded in TIPS breakeven. Barclays has an amazing booklet "Global Inflation-Linked Products: A User's Guide," which has an entire chapter dedicated to this topic. $\endgroup$ – Helin Apr 2 '16 at 23:57
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The difference represents "inflation compensation", or the amount that fixed bond investors must receive over and above the TIPS rate to make them accept the risk of inflation. The inflation compensation is thought to consist of the expected inflation plus a risk premium which varies over time.

https://www.federalreserve.gov/pubs/feds/2008/200805/200805pap.pdf

An older term was "break even inflation" but "inflation compensation" is a better choice and is what Ms. Yellen, for example, refers to. The thinking has evolved. Current thinking is that inflation compensation has 2 parts, only one of which is a forecast of future inflation.

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