Warning: There’s a cash-flow problem with this 30-year TIPS

xx45I’ve raised this issue before, and I hope this is actually the last time I need to raise it, since yields on TIPS have risen dramatically since February 2013.

But here is the problem: If you bid on CUSIP 912810RA8 at Thursday’s auction, in a taxable account (such as TreasuryDirect), you will very likely be cash-flow negative until the TIPS matures 29 years, 4 months from now.

Here are the facts:

  • CUSIP 912810RA8 was originally auctioned on Feb. 21, 2013, with a coupon rate of 0.625%. That coupon rate, the actual interest you receive each year, will never change over the next 29 years.
  • On Thursday, you can buy CUSIP 912810RA8 at a substantial discount, because the yield to maturity is now running about 1.30%. That means you can buy this TIPS at about $83.10 for $100 of value.
  • However, buying at a discount means you are more or less buying a zero-coupon TIPS, so you pay $83 today and get $100 in February 2043.
  • So, let’s say you buy $100,000 of this TIPS at auction Thursday, in a taxable account. You’ll pay maybe $83,000 for that $100,000 value. (I am ignoring any adjustment for accrued principal since February.)
  • For the next 29 years, you will be getting about $625 of income from the TIPS coupon rate of  0.625%. The yearly payout will grow with inflation, as the TIPS principal rises.
  • Also, the TIPS principal balance will climb with the rate of inflation. So if inflation averages 2.5%, your principal will increase about $2,500 a year, rising with inflation.

And there is the problem …

  • The IRS views the inflation adjustment to principal a taxable event for the current year. So you’ll owe income taxes on $3,125 a year ($625 + $2,500) in 2014. If you are in a 38% federal tax bracket you would owe $1,187.50.
  • But your coupon rate gives you only $625 a year.
  • You are cash-flow negative $562.50. If inflation averages higher than 2.5%, then you’d be even more cash-flow negative.
  • That will continue for 29 years until the TIPS matures and you get your zero-coupon payout of $100,000 plus inflation.
  • At that point, all the money comes to you tax-free, except for the small final interest payment. But it was a long time to wait to go cash-flow positive.

The solution

  • Don’t buy this TIPS in a taxable account.
  • Wait until February 2014, when a new 30-year TIPS will be issued with a coupon rate (hopefully) at 1.54% or higher. That would push your return to tax-flow positive, even in a taxable account, assuming inflation of 2.5%.
  • At 1.54%, you’d get $1,540 in income each year, rising with inflation. At 2.5% inflation you’d get $2,500 in principal adjustment. You’d owe taxes on $4,040. At at 38% tax bracket you would owe $1,535.
  • You are cash flow positive.
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One Response to Warning: There’s a cash-flow problem with this 30-year TIPS

  1. Pingback: Next up: 30-year TIPS will auction Feb. 20, 2104 | Treasury Inflation-Protected Securities

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