Q&A about TIPS

A little story. Back in 1999 I was at a cocktail party, and of course, the conversation drifted toward the red-hot stock market, as  it always did in 1999. What were you buying? Cisco? AOL? Something-or-other.com?

I said, “I’ve been looking at TIPS, Treasury Inflation-Protected Securites.”

Blank stare from the group standing around me, which included several investment professionals.

“No really, TIPS are paying 4% above inflation and are rock-solid safe. Where can you find another investment like that?”

Blank stare. Oh well, change subject.

I did end up buying TIPS that year, and every year since, directly through TreasuryDirect.gov. Those TIPS I bought in the late 1990s were fantastic investments, returning 3 to 4% above inflation while the stock market had a negative real return over the same time.

Sure, I had money in the stock market, too. But the TIPS investments were sort of ballast for my financial ship. That investment was not going down. That investment was 100% safe.

So today, TIPS are nowhere near as appealing, paying a yield to maturity that’s negative to inflation well up the maturity ladder. And this is at a time that the stock market seems pretty fairly valued. And yet TIPS are now massively popular — go figure.

The reason is: The risk of inflation is lurking. If it strikes, and I think it will, your regular bond investments (especially in mutual funds) are going to take a big hit. TIPS mutual funds will also be hit — be sure of that.

My premise is to buy and hold TIPS directly from the Treasury and hold them to maturity. It is not a sexy strategy. But is a safe strategy, if you build a collection of these investments over time. And you invest only up to 25% of your portfolio this way, meaning you keep stock market exposure, and some CDs, bond funds, etc.

Key Facts:

• TIPS are issued in terms of 5, 10, and 30 years.
• The interest rate on a TIPS is determined at auction.
• TIPS are sold in increments of $100. The minimum purchase is $100.
• TIPS are issued in electronic form.
• You can hold a TIPS until it matures or sell it in the secondary market before it matures.

Answers to reader questions

If I place a noncompetetive bid for say $1000, do I need to pay more than $1000 if the auction ends above par? Or will my purchase price still be $1000 but with a reduced yield?

When purchased on TreasuryDirect.gov, the price of a TIPS can be less than, equal to, or greater than the face value you are purchasing.

The ‘coupon’ yield does not change, but the price you pay can be higher or lower than the amount of TIPS you are buying. This is from TreasuryDirect.gov:

The price of a fixed rate security depends on its yield to maturity and the interest rate. If the yield to maturity (YTM) is greater than the interest rate, the price will be less than par value; if the YTM is equal to the interest rate, the price will be equal to par; if the YTM is less than the interest rate, the price will be greater than par.

For example, in the April 2011 auction of a 5-year TIPS, you would have paid $5,087.95 for $5,000 of that issue, since that TIPS had a coupon rate of 0.125% but the auction rate was negative 0.18%.

Why does the Treasury issue TIPS with a coupon rate of 0.125% even though the yield to maturity will end up being negative?  

So far, the Treasury hasn’t been willing to issue a TIPS with a zero or negative coupon interest rate. So when yields are negative, it sets the coupon rate at 0.125% and then lets buyers pay up at auction to get the resulting yield that is negative to inflation.

Could the coupon rate be zero? I don’t see why not, in theory. I Bonds do have a zero base interest rate, but they get the inflation add-on, so I Bonds can’t go below zero interest, even if inflation is negative. That makes I Bonds more attractive than TIPS at pretty much all maturities.

If I buy via Treasury Direct and pay more than par or 100, say $107.06 for a coupon rate of 0.125% to result in a negative yield, then is the 7.06 premium ‘protected’ if a chronic deflation sets in? In other words, at maturity will the Treasury reimburse principal of 100, or of 107.06?

When you pay $107.06 for a TIPS at auction, you are paying up to receive that 0.125% coupon rate. After ten years, you get back $100, plus any inflation adjustment to principal. So you are paying $107 for $100, simple as that. If we suffered through chronic deflation for 10 years, you’d get back $100.

But … since you’ve been paying taxes on that 0.125% interest all those years, you can take a long-term capital loss on the purchase price difference. (Of course, I am not a tax attorney, so don’t trust me.)

TIPS protect you against ‘chronic deflation’, sort of, since you will get at least the $100 back at maturity, no less, plus you would have earned 0.125% over the 10 years. Earning 0.125% in a time of long-term deflation is not so bad.

(I Bonds are better, because your principal balance will never go down. The worst you could see is a period of time with zero interest.)

If you own a TIPS with substantial inflation appreciation – I bought some 30-years back in 1999, for example – then a month of deflation lowers your principal balance, just as inflation would raise it. That’s happened a few times in the last decade.

How often does the value of the principal get updated in TreasuryDirect to reflect the CPI?

The adjustment is daily, based on the non-seasonally adjusted Consumer Price Index (CPI-U). But since the Treasury only pays interest twice a year, the effective adjustment happens with each interest payment, a half a year at a time.

If you want to track the value of your holdings, I find this Barrons chart helpful. It shows the updated accrued principal for each issue.