New investors are baffled by Treasury Inflation-Protected Securities. Can’t blame them.
By David Enna, Tipswatch.com
A year ago, while real yields for Treasury Inflation-Protected Securities were still deeply below zero, I worked with a Wall Street Journal reporter on a detailed story about investing in TIPS. Things got difficult when we got to the subject of “real yield to maturity.”
Financial reporter: “This doesn’t make sense. What is my actual return? If inflation is 7.0%, why isn’t my real yield to maturity 7.0%? I don’t get it. I’m going to leave real yield to maturity out of the article.”
Me: “You can’t do that! It’s too important. It’s the key to understanding TIPS and investing in TIPS. Your editor will never approve it.”
Wrong. The article on investing in TIPS was written, approved and published, without ever mentioning real yield to maturity.
A year later, TIPS are a rising star of the investment world, with … er … real yields to maturity at their highest levels in 12 to 15 years, much higher than the future yield of highly popular U.S. Series I Savings Bonds. Now I am getting a lot of questions about TIPS. I have a Q&A on TIPS that answers many of those questions, but I thought it would be helpful to discuss, in detail, the complex language of TIPS. If you understand the language, you will better understand TIPS.
Par value is the bedrock of a TIPS investment. At some point, when you buy a TIPS at auction or on the secondary market, you will enter a dollar amount in a box. The dollar amount you enter is the par value of the TIPS you are purchasing.
Par value, almost always, is not what you will actually pay for that TIPS. The actual cost will be determined by a combination of factors, but par value is 1) the amount the Treasury guarantees will be returned to you at maturity, no matter what happens with inflation, and 2) the base amount you will use to determine the current accrued value of your TIPS.
After the initial auction of a TIPS, the Treasury sets its coupon rate at the 1/8th-percentage-point increment below the auctioned real yield. (All coupon rates are set at 1/8th percentage points … 0.125%, 0.250%, 0.375%, etc. If the TIPS auctions with a negative real yield, it gets a coupon rate of 0.125%, the lowest the Treasury will go for a TIPS.)
For example, at the July 21, 2022, auction of a new 10-year TIPS, the auctioned real yield was 0.630% and the coupon rate was set at 0.625%.
The coupon rate remains the same until that TIPS matures, even if the real yield to maturity rises or falls in the future. For example, that July TIPS later reopened in November with a a real yield of 1.485%, but its coupon rate remained at 0.625%.
The coupon interest on a TIPS is biannual, paid out every six months. It is not reinvested. But while the coupon rate remains the same, the amount actually paid will rise (or possibly fall) to match the accrued principal of the TIPS.
Real yield to maturity
What is it? It is the total return your TIPS investment will earn above (or below) official U.S. inflation for the term of the TIPS. The term “real yield” means “yield above inflation.” Other Treasury issues and bank CDs have a defined “nominal” yield, but investors can’t know the future real yield. TIPS have a defined real yield, but investors can’t know the future nominal yield. It all depends on future inflation.
The real yield of any TIPS is constantly changing, based on market sentiment. But the important factor is: When you buy a TIPS you plan to hold to maturity, you have set in stone your real yield to maturity. The market may reprice that TIPS, but your real yield doesn’t change, unless you sell before maturity.
A key thing to remember about the real yield: After you purchase a TIPS, and pay a premium or discount to par value to create the real yield to maturity, this is what you will earn going forward:
Inflation accruals + coupon rate
In other words, your real yield was set by the price you paid. After that, you earn the rate of inflation + future coupon payments.
Pricing of a TIPS
How is the price of a TIPS determined? At the original auction, investors bid based on the desired real yield to maturity, because at that point there is no set coupon rate. At a reopening auction or on the secondary market, investors know the coupon rate, so bidding is based on how much the real yield will vary from that coupon rate.
You will see TIPS prices based on $100 increments, and that is how much you will pay for $100 of the TIPS’ current value (par value + inflation accruals). If the coupon rate is below the market real yield, then the price of the TIPS will be lower than $100. If the coupon rate is higher than the market, the price of the TIPS will be higher than $100. Here’s an example of how that worked for the 10-year TIPS issued in July 2022:
Originating auction. Even at an original auction, the TIPS price is unlikely to be exactly $100. That’s because: 1) the coupon rate will be slightly below the auctioned real yield (when the real yield is above 0.125%), and that will slightly lower the price you pay, and 2) even a new TIPS will have some inflation and interest accruals. A new TIPS is issued on the 15th of the month, but the settlement date is on the last business day of the month. So an investor is getting about 15 days of accrued inflation and interest.
Take the July 2022 10-year TIPS as an example:
The auctioned real yield, called “high yield” in this chart, was 0.630%, so the Treasury set the coupon rate at 0.625%. That set the unadjusted price for par value at about $99.951. But then you have to calculate in the fact that this TIPS would have an inflation index of 1.00495 on the settlement date of July 29, plus it would earn a few cents of interest in those 14 days.
- $100 par value x .99951 unadjusted price = $99.952
- $99.952 x inflation index of 1.00495 = $100.446 adjusted price
- Plus the investor would prepay for about 2 cents of accrued interest.
Reopening auction. Now let’s quickly look at the result of the 10-year TIPS reopening auction on Nov. 17 for this same TIPS, CUSIP 91282CEZ0. Over the four months from the originating auction, real yields soared higher, so the pricing was quite different.
Note that the coupon rate remained at 0.625%, set by the original auction. But the auction resulted in a much higher real yield to maturity, 1.485%. And because of that, the price paid by investors was deeply discounted.
- $100 par value x .92312 unadjusted price = $92.3126
- $92.3126 x inflation index of 1.02147 = $94.2946 adjusted price
- Plus the investor prepaid for about 23 cents of accrued interest
The key factor here is that the real yield to maturity was created by market demand, and because the real yield was higher than the coupon rate, the price of the TIPS was lower. When you buy a TIPS, whether at an opening or reopening auction or on the secondary market, the real yield to maturity is the key factor to consider. If you hold to maturity, it sets your future return over U.S. inflation.
Non-competitive bidders — that’s all of us — at both new and reopened TIPS automatically get the high yield. Big-money investors make competitive bids, which could be rejected. All winning competitive bids also get the high yield.
Accrued interest. As a side note, you pay for the accrued interest after the sale closes, but this money is not added to the principal of the TIPS. You will get that money back at the next coupon payment; in the case of this July 2022 TIPS, on January 15, 2023.
Inflation accruals for TIPS are based on non-seasonally adjusted inflation from two months earlier. The Treasury takes that inflation number and creates an inflation index that changes every day, up or down depending on if inflation was positive or negative two months earlier. For example, non-seasonally adjusted inflation rose 0.41% in October 2022, so TIPS inflation accruals in December are rising 0.41.%. In November, non-seasonal inflation dropped 0.10%, so inflation accruals will decline 0.1% in January.
Each month, on the day the U.S. inflation report is released, the Treasury issues new inflation index ratios for all TIPS for the month two months ahead of the report. Here is the full list of January inflation indexes, based on November inflation. And here is how those numbers look for the TIPS issued in July, CUSIP 91282CEZ0:
In that chart, note that the index ratio for Jan. 1 is 1.02569 and through the month will decline to 1.02469 on Jan. 31 because November was a slightly deflationary month. These inflation indexes are crucial because they set the base principal amount for all TIPS, every single day. That means if you sell a TIPS on the secondary market, you will get the full value of your earned inflation.
Accrued principal value
TIPS have a “market value” — set by the market based on constantly changing real yields to maturity, but also a “current principal value,” which ignores the market shifts and simply measures the current total of par value + inflation accruals. If you are holding to maturity, you can simple track the current accrued principal value with this equation:
Par value x inflation index = Accrued principal
If you bought $10,000 par value of a TIPS and it currently has an inflation index of 1.05672, that TIPS now has $10,567.20 of accrued principal. That number is important because it is the base for the next coupon payment. As it rises, the coupon payment also rises.
At maturity, any TIPS will pay par value x inflation index, along with one final coupon payment. It’s not complicated if you hold to maturity.
Current market value
The accrued principal value is one factor used to determine the current market value of a TIPS on the secondary market. As market real yields rise and fall, the price of the TIPS rises and falls. So the price could be $90 for $100 of value, or $110 for $100 of value, depending on how much the coupon rate varies from the market-set real yield.
Secondary market purchase. When you purchase a secondary-market TIPS at a brokerage, you will be putting a dollar amount in a box, just like at TreasuryDirect. But that is not what you will pay. It is the par value you are purchasing. Your actual purchase would look something like this for a TIPS with a price of $95 and an inflation accrual of 1.15:
- You place an order for $10,000 par value
- Principal you are purchasing: $10,0000 x 1.15 = $11,500 accrued value
- Your cost: $11,500 x .95 = $10,925
- Plus some small amount of accrued interest.
- And in some cases, a brokerage commission.
So, in this simplified example, you’d be paying $10,925 for $11,500 of principal. From that moment on, until maturity, you’d be earning inflation + coupon payments. You accepted a below-market coupon rate, but were rewarded with a price discount. It all balances out. Par value is $10,000, so even if severe deflation strikes, you are guaranteed to receive at least $10,000 at maturity, along with coupon payments along the way.
As you go through the brokerage purchase process, you may see “yield to worst” listed as the yield. That is the real yield to maturity. This “worst” terminology refers to callable bonds, but TIPS aren’t callable and the worst yield is the actual real yield to maturity.
Inflation breakeven rate
This is a measure of market sentiment toward future inflation. It is calculated by subtracting the real yield of a TIPS from the nominal yield of a Treasury of the same term. For example, at the Dec. 20 market close, the 10-year inflation breakeven rate was 2.24%, based on Treasury estimates.
- 10-year Treasury note was yielding 3.69%
- 10-year TIPS had a real yield of 1.45%
- 3.69% – 1.45% = 2.24%
Keep in mind that the inflation breakeven rate isn’t a great predictor of future inflation. It just measures market sentiment. Here is the trend in the 10-year inflation breakeven rate from 2003 to 2022. Look at the 2012 to 2108 era. Do you see any prediction or even hint of our current surge to 40-year-high inflation, topping 7% a year over the last two years?
The inflation breakeven rate is a useful tool, however, because it shows how “expensive” TIPS are versus a nominal Treasury. The lower the inflation breakeven rate, the cheaper the relative cost of a TIPS. Right now, with the 10-year at 2.24%, we are at the border of expensive, but the inflation trend has dramatically changed in the last two years. TIPS look attractive, in my opinion.
I know that TIPS are an esoteric and confusing investment. I was at a party the other night and a friend told me, “I have TIPS in my portfolio but I have no idea how they work.” Yeah, I hear you. Things get less complicated if you invest in individual TIPS and hold to maturity, ignoring market swings. Then you can track current value with a simple Excel spreadsheet: Par value x inflation index.
I am sure I didn’t get close to answering all the possible questions or solving all the mysteries. I’ve been writing about TIPS for more than a decade and I still come across new concepts. It’s a learning process and I hope this article helps. If you did find this article helpful, please share it with friends who are new to investing in TIPS.
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David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.