Seperating Yield Elements
The yield a bond pays can be viewed as a combination of three elements: the risk-free rate of return, an inflation premium and a credit risk premium. Calculating the inflation premium is a matter of separating this element from the others. Start by checking the current rates for Treasury bonds and Treasury Inflation-Protected Securities with the same maturity. Investors use the yields of these government securities to calculate inflation premiums, because they have virtually no credit risk, so you only need to separate the risk-free rate return from the inflation premium. The principal of TIPS bonds is adjusted for inflation, so the yield represents only the risk-free rate of return. Subtract the TIPS yield from the yield of the Treasury bond to find the inflation premium. For example, if the TIPS bond pays 2.5 percent and the Treasury bond pays 5.5 percent, the inflation premium is 3 percent.