Yes, real yield is important, but there are other factors to consider before making a TIPS purchase. Like: How much is this going to cost?
By David Enna, Tipswatch.com
As real yields continue to slide lower, a lot of investors are feeling a sense of urgency to build a ladder of Treasury Inflation-Protected Securities: Let’s get this done! And that means crawling through the secondary market looking for TIPS to fill year-by-year rungs of an investment ladder.
Of course, the trend of declining yields could reverse, and we could see attractive opportunities later this year. Or … we could see a repeat of 2019, when the 10-year real yield fell from 0.96% on Jan. 2 to 0.15% on Dec. 31. My thinking: This is a reasonable time to work on a TIPS ladder, if that is your goal. Real yields remain attractive, at least by the standards of the last dozen years.
I am getting a lot of questions about TIPS on the secondary market. Is real yield to maturity the only important factor to consider? Why do TIPS with similar maturity dates have different real yields? Is it bad to invest in a TIPS with a high inflation accrual? What about the coupon rate and its effect on price?
In this article I am going to run through five pairs of TIPS with the same or similar maturity dates, but in some cases vastly different up-front investment costs and slightly different real yields. Why does that happen and what is important to consider?
First, some definitions
Par value is the base amount of the TIPS you are purchasing. However, the price you actually pay is going to vary from par value. When you buy a TIPS on the secondary market, you will place a dollar amount in the order box. That is the par value you are purchasing. It is also the amount that is guaranteed to be returned at maturity, even if severe deflation sets in.
For more on the language of TIPS, see my TIPS In-Depth page.
The coupon rate is set by the original TIPS auction. It is the amount of annual interest your TIPS will earn on its inflation-adjusted principal. It is the key factor determining the cost of the TIPS on the secondary market. If the coupon rate is below market real yields for that maturity date, the price will be at a discount. If it is higher, the price of the TIPS will be at a premium.
The real yield to maturity is the amount you will earn above official U.S. inflation as long as you hold the TIPS. It is set through a combination of the coupon rate and the price you paid for the TIPS.
After you buy a TIPS, you are going to earn inflation accruals + coupon rate. That’s it. The price you originally paid — at a discount or a premium — determines your real yield to maturity. While the real yield changes minute-by-minute on the secondary market, once you make a purchase you have locked in your real yield to maturity for that TIPS.
You may see “yield to worst” quoted by the brokerage. For a TIPS, that is the real yield to maturity.
The inflation index is the current amount of accrued inflation already earned by the TIPS you are purchasing. This is stated as a number higher or lower than 1.0. If you are buying a new TIPS at auction, the inflation index is likely to be close to 1.0, or even slightly below. But a TIPS on the secondary market usually will have an inflation index above 1.0, even as high as 1.8.
The Wall Street Journal’s daily listing of TIPS values calls the inflation index “accrued principal” and shows it as a number like 1579. Your brokerage would show that as 1.57905. Vanguard calls it “factor.” Fidelity calls it “inflation factor.” What it means is that this particular TIPS has accumulated 57.9% of accrued inflation above the par value.
Adjusted principal is the amount of principal you are actually purchasing. It’s a simple calculation.
Par value x inflation factor = Adjusted principal.
For example: $10,000 par x 1.57905 = $15,790.50 adjusted principal.
Cost factor is the price you are paying for $100 of accrued principal in this TIPS. At the brokerage you will see “bid” and “ask” prices. You will probably be paying the ask price. It will look something like 97.19 for a TIPS selling at a discount or 100.81 for a TIPS selling at a premium. As I noted earlier, this cost factor is based on the coupon rate of the TIPS versus current market real yields for that maturity.
Investment cost is another simple calculation:
Adjusted principal x cost factor = Investment cost
For example: $15,790.50 x 1.0081 = $15,918.40
Note that in this calculation the cost factor is divided by 100 (100.81 / 100 = 1.0081) to reach a dollar-for-dollar multiplier.
And one more thing: Accrued interest will be added on to the investment cost at the settlement. It reflects the amount of unpaid coupon interest up to the date of the settlement. This is generally a small number, and it gets returned to the investor at the next coupon payment.
Here is an example of pricing for the Jan. 19 auction of a new 10-year TIPS, showing the interaction of these price factors:
TIPS vs TIPS: Examples
Because the Treasury used to issue 20-year TIPS (until it stopped in 2009) there are several examples of TIPS maturing on the same day in the future, but with different coupon rates, different prices, different adjusted principal and different real yields. These offer a chance to examine why real yields could vary slightly for these TIPS maturing on the same day. Is one a better investment than the other? That’s up to you to decide.
Example one: 2025
One thing to notice right away is that these two TIPS have real yields that look highly attractive, around 1.95% above inflation. But keep in mind that yields for very short-term TIPS tend to skew high. One has a coupon rate of 2.375%, so it is selling at a slight premium ($100.81), while the other has a coupon rate of 0.250%, so it is has a much lower price ($96.79).
Also notice the inflation accruals. CUSIP 912810FR4 has an inflation index of 1.57905, while CUSIP 912828H45 has an index of 1.25666. So with one you are buying $15,790 of adjusted principal and with the other, $12,566.50.
Opinion: Investors are demanding a slightly higher real yield for CUSIP 912810FR4 because of its higher inflation accrual. Remember, only the par value of $10,000 — not the $15,918.40 investment cost — is guaranteed to be returned at maturity. My opinion: I’d prefer investing in CUSIP 912828H45 and getting the additional principal at a discounted price.
Example two: 2026
This is similar to example one. CUSIP 912810FS2 has a higher coupon rate but also 49.9% extra accrued principal, versus 25.2% for CUSIP 912828N71. Investors are demanding a slightly higher yield for CUSIP 912810FS2 because of the additional principal, which will purchased at a premium price.
Opinion: Again, I would prefer investing in CUSIP 912828N71 to get the additional principal at a discounted price. Why buy additional, unprotected principal at a premium price?
Example three: 2027
Same pattern: Investors are demanding a slightly higher real yield for CUSIP 912810PS1 because of its higher inflation accrual and premium price. Investors in CUSIP 912828V49 are getting additional principal at a discounted price.
I will note that getting a coupon rate of 2.375% versus 0.375% means CUSIP 912810PS1 gets some additional protection against deflation, since the full coupon interest rate will be paid out, even if the semi-annual payments decline with declining inflation accruals. That’s one reason the real yields remain very close.
Opinion: I’d still go with CUSIP 912828V49’s lower investment cost and lower cost on the inflation accrual.
Example four: 2029
No surprise here: CUSIP 912810PZ5, with its premium price and much higher inflation accrual, gets a higher real yield than its January 2029 partner. Investors want to be compensated for the additional risk — although slight — of the higher above-par principal.
Opinion: I’d actually be a fan of buying lots of additional principal, if it was coming at a discounted price. But in this case, only CUSIP 9128285W6 fits that requirement.
Example five: 2030
Because the Treasury stopped issuing 20-year TIPS in 2009, there is only one TIPS maturing in January 2030, CUSIP 912828Z37. I am comparing it with CUSIP 912828ZZ6, a TIPS that matures six months later in July 2030. I like this comparison because these TIPS are very much alike, both with coupon rates of 0.125%.
But take a look at the inflation indexes. The older TIPS, CUSIP 912828Z37, actually has a lower inflation index that the newer TIPS, 1.15688 versus 1.16090. Why would that happen? Because CUSIP 912828Z37 was issued in January 2020 and got hit by deflationary months in November 2019 (-0.05%), December 2019 (-0.09%), March 2020 (-0.22%) and April 2020 (-0.67%).
By the time CUSIP 912828ZZ6 was issued in July 2020, that deflationary spurt was completed. So even though it has six fewer months of inflation accruals, it has a higher inflation index.
But the interesting thing is that CUSIP 912828ZZ6 has a higher real yield: 1.21% versus 1.16% and a lower total cost of investment in $10,000 par.
Opinion: It’s a close call, but in this case I’d prefer CUSIP 912828Z37, with its higher real yield, lower inflation accrual and lower total investment cost.
Final thoughts
Sorry for this long-winded post. I hope it doesn’t add to investor confusion. Yes, a TIPS seems like it should be a simple, no-nonsense investment, offering inflation protection and capital preservation. But the deeper you dive into the TIPS market, the more complex it seems. Questions to ask before you make a secondary market investment in a TIPS:
- How much am I actually looking to invest? For many of these TIPS, the actual investment cost will be much higher than the par value you enter when you make the order. Adjust accordingly.
- What is the market real yield for the maturity I am considering? You can check the Wall Street Journal listing to get a decent idea of current trends.
- Do I care if I am buying a substantial amount of inflation-accrued principal that is not protected against deflation? (Some investors do care; many don’t worry about it.)
- Do I care if I am paying a premium price for that inflation-accrued principal?
- Is there a reason I would prefer a higher coupon rate (at a higher cost) versus a lower coupon rate (at a lower cost)? Or vice versa?
- If I am buying a small investment, am I OK with the fact that I will probably get a lower real yield based on the bid-ask spread?
- Is a higher real yield to maturity the overriding decision-maker for you? Or do these other factors matter?
Have additional thoughts? Post them in the comments section below.
• Confused by TIPS? Read my Q&A on TIPS
• TIPS in depth: Understand the language
• Upcoming schedule of TIPS auctions
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David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. I Bonds and TIPS are not “get rich” investments; they are best used for capital preservation and inflation protection. They can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.
Not sure exactly what that is getting at, but I think "originally issued date" is referring to the par value,…