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What are TIPS – Treasury Inflation Protected Securities

Treasury inflation-protected securities
are often called tips for short tips are a type of government bond that accounts
for the fact that prices of goods and services change over time they call this
inflation let’s look a bit closer first let’s imagine that you bought $1,000 of
a typical 30 year Treasury bond and this bond pays interest at a rate of 3% per
year this is called the nominal interest rate nominal simply means the interest
rate you receive before inflation if you adjust the interest rate by inflation
well they call this the real rate of return so you can calculate the real
rate of return by simply taking our three percent and subtracting inflation
as measured by the consumer price index often called CPI so if the CPI shows
that inflation went up by let’s say 2% while our real rate of return for these
government bonds is just 1% but here’s where it gets interesting
to illustrate inflation movements here’s an actual chart of the CPI since the
1950s and yes inflation went a bit nuts in the 70s and early 80s but you can see
that inflation hit almost 4% as recently as 2011 and 5% in 2008 so what are the
alternatives this is where tips or Treasury inflation-protected securities
step in you can buy tips for 5 10 or even 30 year terms but let’s stick with
our 30-year example so you invest the same 1,000 dollars in tips and let’s
imagine that this 30-year tips will pay the same 3% as the regular bond it
wouldn’t but we’ll come back to that in a minute so you pay the $1,000 this has
a few names it can be called it can be called principle or face value or even
par value so the face value is your month it’s going to be paid back to you
when the bonds life ends in this case 30 years from now the 3 percent well this
is how much needs to be paid to you the investor each year but government bonds
actually pay interest twice a year so that 3% on the $1,000 is $30 per year
which is $15 every six months simple enough
now this math is true for both regular bonds and TIPS but what about inflation
so let’s imagine that after the first year inflation was 2% well what makes
tips unique is that the face value in our case
the $1,000 is adjusted by the inflation rate so now our face value is
1020 dollars went by tips the interest rate you received when the bond was
issued is locked but the interest payments paid is a reflection of both
the fixed interest rate and the face value of the bond that is adjusted with
inflation so now the 3% interest payment the government owes you is 30 dollars
and 60 cents divide that by 2 to account for the two
payments in a year and you get 15 dollars and 30 cents for this
semi-annual payment so what’s the catch well first off in our hypothetical
scenario we had both a traditional 30-year bond pay 3% and the Treasury
inflation-protected securities a percent the only way this would really happen is
if inflation is expected to be 0% and that’s extraordinarily unlikely sticking
with more realistic numbers it’s more likely that inflation is expected to be
let’s say 2% this would mean that the traditional bond would pay an interest
rate of 3% while tips would pay an interest rate of 1% this accounts the
expected inflation rate so with this in mind our tips worth it well it depends
what’s the average inflation rate for the life of the bond if the inflation
rate over the 30 years averaged more than 2% which is the initial spread
between the traditional and tips well the tips would have a greater total
return if the average rate was less than 2% but the total return would be less
than traditional bonds if inflation was exactly 2% well the total return would
be the same they call this 2% the break-even rate now what about deflation
deflation is when the inflation rate is negative well if deflation occurs the
bond value decreases so if the face value was 1,000 dollars and then the
inflation rate was negative 1 percent while the $1000 would fall by 1% or 10
dollars so now our face value is just 990 dollars and let’s imagine that
deflation stuck around for a little while and although you invested $1,000
at the start your tips term is coming to an end
and currently they have a face value of just 950 dollars what happens when you
go to get repaid your bonds face value well the government will repay you the
full one thousand dollars the rule is that you will be repaid the current face
value or par value par value is the initial face value of the bond in our
case one thousand dollars so if your face value had climbed all the way to
let’s say twelve hundred dollars and the deflation occurred knocking your face
value down to let’s say 1150 well you will be repaid the 1150 since that is
higher than the original par value and for our final point let’s take a quick
look at taxes with either tips or traditional bonds your interest payments
every six months are subject to federal income tax but with tips the adjustment
to the face value due to inflation is also subject to tax which means that if
inflation was the original 2% we mentioned and our $1000 face value was
adjusted higher by that 2% giving us a $20.00 gain well will be taxed on that
$20.00 gain even though we will not be given the $20.00 until the end of the
bonds life they call this phantom income if deflation occurs while our phantom
losses can now be used to offset our taxes if you have any questions about
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10 thoughts on “What are TIPS – Treasury Inflation Protected Securities

  1. So, if inflation is 2% first year and 3% second year with a interest rate of 1%, we have a (1000 × 1.02) 1020*0.01=10.2 interest first year.
    And a (1020×1.03) 1050.6×0.01=10.506 interest the second year.

  2. So if inflation became ridiculously high like 8-10%, and you owned a fair bit in TIPS, you would be paying a substantial amount in taxes without getting a lot back? (assuming the TIP still has a long life)

  3. TIPS have been offered for about the last 6 years to many in State admin
    as part of their 457 and 401k. Their returns have been horrible and especially due
    to high cost ratios that eat up their returns. However, as I am writing this in Sept 2019
    I am a huge fan of TIPS and think they will do very well for the next few years in providing


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