Q&A about TIPS

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 every year since, directly through TreasuryDirect.gov. 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 up to 25% of your portfolio this way, meaning you keep stock market exposure, and some CDs, bond funds, etc.

Key Facts:

  • TIPS are issued in terms of 5, 10, and 30 years.
  • The interest rate on a TIPS is 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 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 noncompetetive bid for say $1000, do I need to pay more than $1000 if the auction ends above par? Or will my purchase price still be $1000 but with a reduced yield?

When purchased on TreasuryDirect.gov, the price of a TIPS can be less than, equal to, or greater than the face value you are purchasing.

The ‘coupon’ yield does not change, but the price you pay can be higher or lower than the amount of TIPS you are buying. This is from TreasuryDirect.gov:

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 do 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 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 a 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. (Of course, 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, 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 2012 and you can see the pattern: https://tipswatch.com/2012/12/30/recapping-2012-the-year-in-tips/

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%:

exampleIn 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.

21 Responses to Q&A about TIPS

  1. sliffle says:

    I have a couple questions for which I have not readily found answers online:

    1. If I place a noncompetetive bid for say $1000, do I need to pay more than $1000 if the auction ends above par? Or will my purchase price still be $1000 but with a reduced yield?

    2. How often does the value of the principal get updated in TreasuryDirect to reflect the CPI?

  2. tipswatch says:

    Sliffle, great questions. I added answers to these at the bottom of the ‘Why Tips’ post.

  3. slizzle says:

    Appreciate the site. Since you advocate buy-and-hold through Treasury Direct I am wondering if you would care to post about some issues this brings up. 1) Tax efficiency. Many would argue that TIPS are tax-inefficient when not held inside a tax-advantaged instrument. How much of a disadvantage does this bring you using your strategy? How less attractive are TIPS when held in this way? 2) Laddering. Buy-and-hold to maturity through treasury direct involves constructing a careful ladder and I’m wondering if you have any insights about how you’ve done that with TIPS

  4. Pingback: Who should buy Treasury Inflation-Protected Securities? | Treasury Inflation-Protected Securities

  5. Pingback: How can I tell if I am going to pay a premium or discount at a TIPS auction? | Treasury Inflation-Protected Securities

  6. Mark Williams says:

    I am waiting for interest rates to rise before investing in TIPS. In your opinion – is it likely that there will be a rush to purchase TIPS when this occurs, and the yield to maturity will increase, stay the same, or decrease from today’s near-zero amount?

    Thank you for your column.

    TIPS-waiter

  7. Rajeev Batra says:

    Hullo TipsWatchers, I have a question re secondary market purchases. It seems like the TIPS available to buy on the secondary market are for very few years (I cannot find, as of Nov14, TIPS for sale for the years 2032 through 2039). Any advice on how to find/buy them?

  8. tipswatch says:

    Rajeev, because the Treasury stopped issuing 30-year TIPS between October 2001 and February 2010, there are many gaps in the TIPS ladder. Another problem is that Treasury no longer issues 20-year TIPS. So there are only six TIPS that mature after 2029, ranging in years from 2032 to 2044. This Wall Street Journal list shows all the maturities:

    http://online.wsj.com/mdc/public/page/2_3020-tips.html?mod=topnav_2_3021

  9. rajeevba says:

    Thanks, I had seen this list, had just assumed that owners of TIPs from the I missing years had just not put their bonds up for sale. So they just don’t exist!! I guess I’ll have to buy non TIPS bonds for those other years (for my ladder)…

  10. Frank says:

    If I want to have $30,000 in a TIPS that has a 1.1 inflation factor is it accurate to assume that I can purchase about $27,300 of this TIPS? My risk being that if deflation sets in, the value could go back to $27,300 at maturity whereas if I had bought $30,000, the value would still be $30,000.

    What are your thoughts on building a 30 year TIPS ladder by buying a TIPS for each year 1-10 and buying one 10 year TIPS to cover years 11-30? When that TIPS matures, it would be used to purchase a TIPS for each year of the the next 10 years plus one to cover years 21-30. Understand about reinvestment risk but seems this might keep things a bit safer/simpler/more flexible particularly if I depart this realm prematurely. I am 67 and these funds would cover my annual spending gap after social security. Interest income is not my goal but rather inflation protected return of principal…wish TIPS STRIPS were available.

    Thanks
    Frank

    • tipswatch says:

      Frank, if you are buying on the secondary market, the price you pay will be determined by the current yield to maturity (which sets the cost per $100) and the accrued principal. If the cost is $100 for $100 of par value, then you would actually be paying $110 for $100 of par value, plus $10 of accrued principal. So if you wanted accrued principal of $30,000 you would buy about $27,273 of par value. And you are right, your deflation protection only covers the par value, not the accrued principal.

      Not sure what you mean on the TIPS ladder. For my ladder, the 10-year TIPS is the basic investment, but I only buy at original auctions. I have two 30-year TIPS holding up the high end. I generally buy one 10-year TIPS a year, and if I skip a year I use a 5-year to fill the hole in the ladder. I keep rolling over the 10 years. Reinvestment risk is an issue — we had a severe case of it from 2011 to 2014. I hope things will be getting better in future years.

      • Frank says:

        Thanks…I was thinking in terms of spending each TIPS as it matures rather than rolling them.

  11. Jake says:

    I am new to TIPS and I really appreciate all the information on your site (it is the best place I’ve found for real information on TIPS). As part of my education I’ve started looking at different TIPS for sale on the secondary market. I’ve found a listing that seems too good to be true, so I must be missing something. Would someone examine this and tell me what I’m not seeing?

    Vanguard has CUSIP 912828et3 listed with an asking price of $99.890. According to their data the Yield to Worst is 2.281% with a modified duration of 0.385. The TIPS matures 1/15/2015, has a coupon of 2%, a Factor of 1.2014, and price as Issue was $99.72283

    Now, here is where I’m sure my calculations are wrong….
    1) If the factor is 1.2014, then the current bond value is $120.14.
    2) 2% of $120.14 is $2.4028 * the duration = $0.925 in interest.
    3) Assuming the Factor stays at 1.2014 at Maturity you would be paid $120.14 in principal for the bond.
    4) Assuming a purchase price of $99.890, that would mean a gain of $20.25 in principle and $0.925 in interest (a total gain of $21.175 or 21.1%).

    I was originally thinking the YTW of 2.281% was too good to be true (with a 0.385 duration a real Yield of 0.88% for roughly 4 months). However, after doing the calculations I’ve come to the conclusion I clearly don’t understand how TIPS work. I must have something very wrong.

    If someone can follow my logic above and show me the error of my ways I would greatly appreciate it.

    • tipswatch says:

      Yields on very-short term TIPS get wacky, possibly because they are condensing a few months of yield into an annualized number. Also, this TIPS has just one bi-annual interest payment remaining, on Jan. 15, 2016. So the coupon is actually 1%, not 2%, since only one payment remains. Still, that could be an excellent investment. But I imagine that trading in this TIPS is extremely thin.

      On the price … If you want to buy $1,000 of par value for this TIPS you will actually pay $1,201.40, not $1,000, because you are buying the accrued principal. Even if you buy it at a slight discount, you’ll end up earning about 1%, not 20%. But that is still a nice gain, if the numbers work out.

      And then the other risk — and possible explanation for the yield — is that falling gas prices will cause deflationary CPI numbers over the last few months of this year. That will reduce your $1,201.40 investment by the amount of the deflation. You are guaranteed to get only $1,000 at maturity. Your 1% could disappear.

      Like I said, I am mystified by these short-term yields, though. Maybe others have some explanations.

      • Jake says:

        Tipswatch, thank you for your reply… It opened my eyes (at least a little). You are absolutely correct that we would be paying for the accrued principal! That was one thing I missed. With normal bonds there isn’t accrued principal, only accrued interest, so that was one thing I missed.

        Another words, when the price is listed as $99.890, that isn’t the real price you will be paying. We have to multiply the asking price by the factor to get the real purchase price (in this case $120.007846).

        Then the interest payment would be a partial payment (interest multiplied by the duration), so $0.925 in interest.

        That means if the factor stayed the same the return would be .77% (real return, not yearly return). This would be a good return for a few months. However, like you said, whoever is on the other side of this trade is betting that the factor will decrease and wipe out this return. It’s interesting because there are a lot of these for sale (this CUSIP has 5,000 for sale, and there are other similar short term setups just like this for sale). Clearly, someone thinks this is a good trade. Since I’m not a trader I’m staying away from this, but it was interesting to explore it and hopefully learn something.

        Thanks for the education…

  12. Dan T says:

    If I expect inflation to be greater than the market anticipates, wouldnt it be an advantage to buy a previous issued tip with a higher coupon rate than the current issues? If I understand it correctly, I will not only have my principal increase with inflation, but the higher coupon rate will also give me more every coupon date than a lower coupon rate? I am considering buying 30 year tips and I like the 1.375 coupon compared to the recent issued 1% coupon in February.
    Does my thinking make sense, if inflation does turn out to be higher in the future than the market anticipates?

    Thank you for any insight you may have on this topic.

    • tipswatch says:

      Dan T, you will pay a higher price upfront for that higher coupon, right now it is about 7% above par value, creating a yield to maturity of 1.07%, slightly better than the 1.03% currently on the 30 year issued this year. If you like the 28 year maturity instead of 30 year, that would be a reason to buy the 28 year. Otherwise, they will perform very similarly.

      • Dan T says:

        Thank you for your kind reply.
        Do you happen to know if there is a yield to maturity calculator for Tips on the net?
        I have found quite a few for fixed, but none that would work for tips and has an inflation input similar to this one for fixed bonds, https://powertools.fidelity.com/fixedincome/yield.do

        Of course I realize that an inflation input would be just a guess but it would allow a projected result based on different scenarios. This would allow me to compute just how significant the different coupon rates and various inflation rates would affect yield to maturity
        thanks Dan

  13. tipswatch says:

    Dan T, you can just look at the closing prices of all TIPS trading on the secondary market:
    http://online.wsj.com/mdc/public/page/2_3020-tips.html?mod=topnav_2_3021
    The yield shown there was the closing yield to maturity for the day shown. That is a ‘real yield,’ meaning the yield above inflation. Whatever inflation is, the TIPS will return that ‘real yield’ above inflation.

  14. Halfdave says:

    good site, question, have you looked at the iShares TIP? is there a closed end fund that gives juice to the basic TIP?

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