Finance Short Response 4

W E B E X T E N S I O N 5B A Closer Look at TIPS: Treasury Inflation- Protected Securities

I nvestors who purchase bonds must constantly worry about inflation. If inflation turnsout to be greater than expected, bonds will provide a lower than expected real return.To protect themselves against expected increases in inflation, investors build an infla- tion risk premium into their required rate of return. This raises borrowers’ costs.

In order to provide investors with an inflation-protected bond, and possibly to reduce the cost of debt to the government, on January 29, 1997, the U.S. Treasury issued $7 billion of 10-year inflation-indexed bonds called Treasury Inflation- Protected Securities (TIPS). Since then, the Treasury has continued to offer TIPS with original maturities up to 30 years. To see how TIPS work, let’s take a closer look at the TIPS that were auctioned on April 7, 1999. These TIPS mature on April 15, 2029, and pay interest on April 15 and October 15 of each year. The bonds have a fixed coupon rate of 3.875%, but they pay interest on a principal amount that increases with inflation. At the end of each 6-month period, the principal (originally set at par, or $1,000) is adjusted by the inflation rate. For example, on April 15, 1999, the Reference CPI (as defined by the U.S. Treasury) was 164.39333. At the time of the first coupon payment on October 15, 1999, the Reference CPI was 166.88065. The Index Ratio is defined as the ratio of the current CPI and the original CPI:

Index Ratio ¼ 166:88065=164:39333 ¼ 1:01513 In essence, this Index Ratio measures the amount of inflation since the bond was first

issued. The inflation-adjusted principal is then calculated as $1,000 (Index Ratio) = $1,000(1. 01513) = $1,015.13. So, on October 15, 1999, each bond paid interest of (0.03875/2)($1,015.13) = $19.67. Note that the interest rate is divided by 2 because in- terest on these (and most other) bonds is paid twice a year.

By April 15, 2000, a bit more inflation had occurred, and the inflation-adjusted principal was up to $1,029.04 (based on the Index Ratio at that time).1 On April 15, 2000, each bond paid interest of 0.03875/2 × $1,029.04 = $19.94. Thus, the total re- turn during the first year consisted of $19.67 + $19.94 = $39.61 of interest and $1,029.04 – $1,000.00 = $29.04 of “capital gains,” or $39.61 + $29.04 = $68.65 in to- tal. Thus, the total rate of return, ignoring compounding, was $68.65/$1,000 = 6.865%. Therefore, if you had been able to buy this bond for $1,000, you would have received a real rate of return of 3.875%.2

This same adjustment process will continue each year until the bonds mature on April 15, 2029, at which time they will pay the adjusted maturity value. Thus, the

1The U.S. Treasury publishes the Reference CPIs and Index Ratios each month. For the April 2000 va- lues, see http://www.treasurydirect.gov/instit/annceresult/tipscpi/2000/of042000cpi.pdf. 2The auction price usually differs slightly from the $1,000 par value.

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cash income provided by the bonds rises by exactly enough to cover inflation, pro- ducing a real, inflation-adjusted rate of 3.375%.3 Further, since the principal also rises by the inflation rate, it too is protected from inflation.

The Treasury regularly conducts auctions to issue indexed bonds. The 3.375% rate was based on the relative supply and demand for the issue, and it will remain fixed over the life of the bond. However, new bonds are issued periodically, and their “coupon” real rates depend on the market at the time the bond is auctioned. In January 2009, 10-year indexed securities had a real rate of 1.86%.

Both the annual interest received and the increase in principal are taxed each year as interest income, even though cash from the appreciation will not be received until the bond matures. Therefore, these bonds are not good for accounts subject to current income taxes but are excellent for individual retirement accounts (IRAs and 401(k) plans), which are not taxed until funds are withdrawn.

Keep in mind, though, that despite their protection against inflation, indexed bonds are not completely riskless. The real interest rate can and often does change. If real rates rise, then the prices of indexed bonds will decline. In fact, if you buy a TIPS in the secondary market, its quoted yield is likely to be somewhat different from the coupon rate because current real interest rates probably are different than they were at the time of issue. Also, as the bond’s remaining time until maturity declines, its maturity risk premium will also decline. Thus, the 3.875% coupon on the bond we have been discussing was a good indicator of the real interest rate for a 30-year bond at the time it was issued in 1999, but that included the maturity risk premium for a 30-year bond.

TIPS are also useful for providing estimates of the inflation premium for a given maturity, which can be estimated by subtracting the TIPS’s yield from the yield of a nonindexed Treasury bond of the same maturity.

3This assumes you had bought the bond at its auction for $1,000 and that you held the bond. It also does not take into account the rate of return you might get on the coupon payments.

2 Web Extension 5B: A Closer Look at TIPS: Treasury Inflation-Protected Securities