TIPS – Treasury Inflation-Protected Securities:

TIPS provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index.

TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation.

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How TIPS work:

• The coupon rate on an issue is set at a fixed rate; determined via the auction process.The coupon rate is called the “real rate”; the rate that is earned above the rate of inflation.
• The inflation index usded for adjustment of payment (for both coupons and principal) is Consumer Price Index (Non-seasonally adjusted; 3-month lag) or CPI-U for short.
• The principal of the TIPS is adjusted semiannually for inflation. If the holder of the security is a taxable entity, they must pay taxes and the adjustment of the principal amount. The coupon is paid off of the higher principal amount.

Example:

Breakeven Inflation Rate:

The yield on a nominal Treasury bond can be looked at as having three components: 1) a real yield, which investors demand after inflation, 2) an inflation expectation, and 3) a risk premium for the uncertainty of those inflation expectations. The market has simplified this by combining the second two components into one term called the breakeven inflation rate as shown in the following simple equation: (Healey, CFA & Varrelman, CFA, 2005)

• Nominal Bond Yield = Real Yield + Breakeven Inflation Rate
• (since TIPS have an inflation adjustment, their yields are considered real yield)
• Breakeven Inflation Rate = Nominal Bond Yield – TIPS Yield

When to buy TIPS: an example

As of 11/2009, the difference between the yields on the current 10-year Treasury (5.5%) and current 10-year TIPS (3.0%), or breakeven inflation rate, was 2.5%. If an investor expects inflation to be higher then 2.5% over the life of the bonds (10 years), then that investor would prefer owning the TIPS; because owing nominal bond should require a yield greater than 5.5%. And vice versa.

The Wisdom of the Cloud:

“Because expected inflation varies over time, long-term nominal Treasury bonds are not safe in real terms; and because short-term real interest rates vary over time, Treasury bills are not safe assets for long-term investors. TIPS fill this gap by offering a truly riskless long-term investment.”

Authors: Campbell, John Y., Shiller, Robert J. and Viceira, Luis M., Understanding Inflation-Indexed Bond Markets (May 1, 2009). Yale ICF Working Paper No. 09-08. Available at SSRN: http://ssrn.com/abstract=1408247

“The price variation of intermediate-term TIPS is greater than that of equivalent traditional Treasuries. Why TIPS are so volatile? Reasons: liquidity or investor irrationality? Bond funds simplify the reinvestment of earnings, as well as that of principal, upon the maturiy of the bond. Owning bonds directly is superior to owning bond funds?”

Author: Allan Roth, Tips on TIPS (Nov 1, 2009). Financial Planning.com

“In evaluating U.S. Treasury inflation-protected securities (TIPS) for fixed-income portfolios, managers frequently use the TIPS’ effective durations, which are much shorter than modified durations. Unfortunately, when the manager’s intention is to profit from a decrease in real rates or an increase in the market’s implied inflation forecast, the use of effective durations will thwart obtaining the objective.”

Authors: Ivan R. Shabinsky, CFA, and Francis H. Trainer, Jr., CFA, Assigning a Duration to Inflation-Protected Bonds (Oct, 1999). Financial Analysts Journal | download

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iShares Barclays TIPS Bond Fund (ETF):

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