Treasury Inflation-Protected Securities are often cited as being reasonably safe against deflation, because when held to maturity they will return the original ‘par’ value, even if deflation strikes with vengeance. In other words, the value can never go below ‘par’ – the original purchase allocation.
But TIPS do lose value when deflation strikes, because deflation eats away at the accrued principal each TIPS carries. If you buy a TIPS at a reopening auction or on the secondary market, you are paying for that accrued principal. When deflation strikes, you lose it, because it isn’t ‘par value,’ it’s an inflation adjustment that goes up with inflation, but will go down with deflation.
An example. To make this simple, I am going to talk about one TIPS – CUSIP 912828C99 – which I bought at a reopening auction on Dec. 18. This was a 4-year, 4-month TIPS with a coupon rate of 0.125%. It auctioned with a yield to maturity of 0.395%.
If you look at the auction results announcement, down at the bottom in tiny type you can see that this TIPS had an inflation index of 1.01337 on Dec. 31, the settlement date. Here it is, a little enlarged:
I bought $10,000 of this TIPS, and on Dec. 31 Treasury Direct withdrew $10,020.14 from my bank account. The par value was $10,000 and the inflation-adjusted value was $10,133.70, as of Dec. 31. I got it at a discount because the auctioned yield was higher than the coupon rate.
(In this article I am using ‘value’ to mean the current held-to-maturity value, not the value on the secondary market.)
CPI and the TIPS inflation index. The Treasury adjusts the value of TIPS based on the non-seasonally adjusted Consumer Price Index for All Urban Consumers. Each month’s CPI inflation index number establishes the TIPS inflation index two months into the future. So the Dec. 31 number was based on non-seasonally adjusted inflation in October, which was -0.25%.
The January inflation index was set by non-seasonally adjusted inflation in November, which was -0.54%. Because of that deflated number, on Jan. 31 the inflation index for this TIPS will drop to 1.00799 and the inflation-adjusted value of my TIPS will be $10,079.90.
The February inflation index was set by non-seasonally adjusted inflation in December, which was -0.57%. Because of that deflated number, on Feb. 28 the inflation index for this TIPS will drop to 1.00231 and the inflation-adjusted value of my TIPS will be $10,023.10.
So, in summary, here is what I received for my $10,020.14 purchase, one month after the auction: $10,023.10 and a 0.125% coupon rate.
Future deflation would continue to drop that inflation-adjusted number, but my value can never drop below $10,000. However, the inflation index can drop below 1.000, and would require future inflation to bring it back above that level. There is one TIPS – CUSIP 912828WU0 – currently trading with an index of 0.997 and that will drop to 0.989 on Feb. 28. This TIPS originated in July 2014, just before the current deflationary swoon.
You can track these inflation index numbers on the Treasury Direct site. Here are the numbers for CUSIP 912828C99.
I Bonds do have an advantage. I Bonds pay a fixed rate for the 30-year life of the holding – currently 0.0% – and an inflation-adjusted rate that changes each May and November – currently 1.48% annualized. The principal of an I Bond grows with each interest payment and can never go down. Deflation could mean six months of zero interest payments, which looks likely beginning May 1. But even at a time of severe deflation, the value of I Bonds will never go down. It’s an advantage they hold over TIPS.
Thanks for this explanation. Earlier this week I was looking over the TIPS available on the secondary market and the YTMs on near-maturing TIPS (< 6 months from now) were much higher than longer-term TIPS — over 5% annualized YTM for the shortest term. I couldn't figure out why, but now it makes sense; if the principal is going to be adjusted downward immediately before maturity, that's going to be reflected in the price, and that pushes YTM to a deceptively high number.
The inflation adjustment is pretty small, under 1%. I can’t figure out why the YTM is boosted to 5%. How does that figure? Is there no coupon payment at maturity, on TIPS, or something like that?
In this case the YTM was annualized, which amplifies small movements in a bond that matures in less than a year. For example, a bond maturing in two months with an actual YTM of 1% would display as 6% annualized.
The recent deflationary trend largely stems from the ongoing oil price war. Oil prices will self correct by supply and demand forces. If you maintain a ladder of 10 year tips held to maturity you should see no impact.
MGK, I agree. The downside risk of TIPS is limited to par, and the upside potential is limited to infinity. But I think people do need to understand that the current wave of deflation, however long it lasts, is eroding TIPS principal.
While slightly annoying, the downside risk of losses from deflation, even on a higher indexed bonds, should not be a major consideration for TIPS investors, as even the worst-case potential for significant losses over time due to deflation is quite minimal. In other words, the risks of inflation/deflation are highly asymmetric, in favor of inflation, and TIPS.
Grant, that April 2029 TIPS is one of the greatest issues of all time. Congrats on owning it. It means you are pulling down 3.875% in current income from that TIPS, and it currently has an inflation index of 1.440. That will drop to 1.428 on Feb. 28, a loss of about 0.8%. You can track that here: https://www.treasurydirect.gov/instit/annceresult/tipscpi/tipscpi_detail.htm?cusip=912810fh6
Still, as Joseph points out above, deflation can switch to inflation pretty quickly, and then these decreases could be reserved.
good discussion on “deflation”. I have a 3.875% tip due April 2029 which I purchased shortly after the issue date. Question, does the very high coupon on this TIP “offset” the risk of losing much of my accumulated inflation adjustments because of future deflation?
I always enjoy reading your posts. I bought CUSIP 912828C99 along with you. I am very pleased with the result. I only paid a few dollars over par for the accrued inflation principal, so only have those few dollars to lose should deflation persist, which I just cannot see happening. My wife does our food shopping and apparently many food items have not gotten the message that deflation is afoot. The fact remain, that when inflation does return, and it will, it could kick up so fast that you will have to pay significant premiums to get into tips. I think this is a great time to buy tips if you can get them near par. I am not planning to go out furhter than five years to hedge interest rate rises. I am a retiree on a pension with no cost of living increases at this time. Delfation actually works in my favor as my pension income remains constant even if deflation rages. On the flip side, I am using these low interest, low inflation preumium tips to hedge my cola-less pension. Thanks for all you do.