David Enna, Tipswatch.com (posted originally in March 2011)
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 many years since, directly through TreasuryDirect for awhile and now through a brokerage in a traditional retirement account. 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 15% to 20% of your portfolio this way, meaning you keep stock market exposure, and some CDs, bond funds, etc.
- TIPS are issued in terms of 5, 10, and 30 years.
- The real yield to maturity and cost of a TIPS are 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
Who should buy Treasury Inflation-Protected Securities?
First off, I want to state loudly that TIPS are for preserving wealth, not building wealth. If you are in the early stages of investing and far from your long-term needs for buying a house or for paying for college or especially for retirement, TIPS aren’t going to be a great investment. That’s especially true when yields are less than 1% over inflation. You probably won’t build enough wealth to meet your goals.
However, if you are nearing retirement, or in retirement, and have an adequate nest egg, then TIPS make sense as part of your investment portfolio – especially if you buy and hold them to maturity. That strategy is risk-free, and you can protect a part of your savings from the dangers of unexpected inflation.
Even then, I think TIPS, I Bonds and bank CDs should make up no more than 30% of your portfolio. Put the rest in stock and bond index funds, whatever matches your risk tolerance. In the past, I have suggested something like:
- 10% Highest risk: International, small cap stock index funds
- 30% Higher risk: U.S. stock index funds
- 35% Lower risk: Broadly diversified bond funds, municipal bonds
- 25% No risk: TIPS, I Bonds, insured bank CDs, Treasuries held to maturity
I Bonds are a special case, since there is a limit on purchases of $10,000 per person per year. If you want to build a large stake, you need to start early. I think I Bonds could work well for almost any investor. They are flexible enough to be a 1-year savings account, or a 30-year investment, with taxes deferred.
What is the difference between the ‘coupon rate’ and the ‘yield to maturity’?
When a TIPS is first auctioned, a coupon rate is set to a rate slightly below the ‘high yield’ bid accepted by the Treasury. Once the coupon rate is set, it stays with that TIPS through its entire term, and determines the interest rate paid on the par value, which climbs with inflation.
At the same time, the high yield becomes the yield to maturity for that TIPS, on the day of the auction. The buyer is paying either a premium or discount to par value, and that creates the actual yield.
Once a TIPS is issued, it can be traded on the secondary market, and its yield to maturity will change each day.
So, for example, on Jan. 23, 2014, the Treasury auctioned new TIPS with a coupon rate of 0.625% and a yield to maturity of 0.661%. Buyers paid about $99.55 for $100 of value to get a coupon rate of 0.625%, and the resulting yield was 0.661%.
On March 20, the Treasury reissued this same TIPS, which still has a coupon rate of 0.625%. On that date, the market set a yield to maturity of 0.659%.
Once set, the coupon rate never changes, but the yield to maturity constantly changes and that causes the market value of the TIPS to rise and fall on the secondary market. If you are holding to maturity, no big deal – ignore the fluctuations.
Buying TIPS at auction: If I place a non-competetive bid for say $1,000, do I need to pay more than $1,000 if the auction ends above par? Or will my purchase price still be $1,000 but with a reduced yield?
When purchased on TreasuryDirect, the price of a TIPS can be less than, equal to, or greater than the face value you are purchasing.
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 can 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 the real yields are similar.
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 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. (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 in times of deflation, 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.
What is the difference between new and reissued TIPS?
While they are all Treasury Inflation-Protected Securities, there are slight differences.
New issue. The Treasury does a TIPS auction each month, and sometimes it is a new issue. That means the base interest rate (coupon rate) and yield to maturity will be set at auction. So for a new issue, you won’t know coupon rate for certain, and the yield you get will end up close to the coupon rate, as long as the yield is positive. The price you pay for the TIPS will be close to par value, as long as the yield is positive.
Reissue. When the Treasury reissues (also called ‘reopens’) a TIPS, it carries the coupon rate from the original auction. A few months will have passed, so the yield could have moved up or down from the coupon rate, meaning the price you pay for the TIPS could be less or more than par value.
Once a TIPS is issued, it trades on the secondary market, so it is easier to estimate its likely value at auction. With a new issue, the price can be a little harder to estimate.
Take a look at this post for a recap of all the new and reissues of 2021 and you can see the pattern:.
When I buy a TIPS, how can I tell if I am going to pay a premium or discount to par value?
For a new TIPS issue going to auction, the coupon rate will be set slightly below the yield to maturity that results from the auction. Coupon rates rise in 0.125% increments. So if the TIPS auctions with a yield of 0.663%, the coupon rate will be set at 0.650% and the buyer will get it at a slight discount to par.
But this does not hold true when the yield to maturity is negative. In that case, the coupon rate is set at 0.125%, the lowest it can go, and the buyer pays a premium to make up the difference.
For reopening auctions, a buyer can look at sources of secondary-market information on the current market yield of the TIPS being auctioned. That can give the buyer an indication of whether the TIPS is going to go off at a discount or premium to par.
A reliable source is the Wall Street Journal’s chart of closing TIPS prices. You need to know the maturity date of the TIPS that’s being auctioned, then check the price on that chart. Here is an example for a TIPS with a coupon rate of 0.625%:
In this case, the yield is 0.583%, so a buyer today would need to pay a premium, which in this case is about $100.40 for $100 of value, based on the asked price of 100.13. By the way, the .08 and .13 in that chart actually mean 8/32 and 13/32, not cents. The Wall Street Journal explains this:
Figures after periods in bid and ask quotes represent 32nds; 101.26 means 101 26/32, or 101.8125% of 100% face value; 99.01 means 99 1/32, or 99.03125% of face value.
Also, the accrued principal will factor in what you pay for a reopened TIPS, because you are also getting the existing boost from inflation since the TIPS was first issued. In this case, accrued principal of 1001 is very small and not much of a factor. If it is higher, it will factor into what you pay, but you are also getting the additional principal.