TIPS – Treasury Inflation-Protected Securities
Fixed income plays a key role in an investment portfolio, especially for those investors who are dependent on current income or planning for future expenditures. Most bonds offer investors a fixed coupon for a specified period and provide a stated rate of return. A concern arises, however, when the investment earns 4% and inflation is running at 3%. This means that the real rate of return – the stated return minus inflation – is only 1%. An investor locks in the money for a period and receives a specific income stream, but if inflation increases, future proceeds may have less purchasing power.
Unlike nominal bonds, TIPS offer a real rate of return and, hence, provide investors with a certain amount of protection against inflation*. By investing in TIPS, investors give up the certainty of a predictable income stream for the assurance that their investment will maintain its purchasing power in case of rising inflation. For that assurance, TIPS often pay slightly lower interest rates than comparable maturity Treasury securities. Some investors choose to diversify their portfolios by purchasing both TIPS and nominal bonds.
Addressing purchasing power risk
TIPS have a stated maturity date and pay a fixed coupon rate. The principal amount is adjusted daily. Since the coupon is paid on the outstanding principal value, the semi-annual payments will fluctuate as well. Increases in consumer prices are reflected in higher principal and interest payments to TIPS holders. Conversely, decreases in consumer prices have an opposite effect on principal and interest payments.
To illustrate, consider the following inflation scenarios on a hypothetical five-year TIPS with a 1.50% coupon rate.
| Year | Coupon | Par Value | Inflation Period | Change in CPI | Adjusted Principal Value | Interest Payment |
|---|---|---|---|---|---|---|
| 1 | 1.50% | $1000 | Inflationary | +2% | $1020 | $15.30 |
| 2 | 1.50% | $1020 | Deflationary | -1% | $1010 | $15.15 |
| 3 | 1.50% | $1010 | Inflationary | +3% | $1040 | $15.60 |
| 4 | 1.50% | $1040 | Inflationary | +2% | $1060 | $15.90 |
| 5 | 1.50% | $1060 | Inflationary | +1% | $1070 | $16.05 |
The change in Consumer Price Index for all urban consumers CPI-U is represented by a factor which is reflected in the adjusted principal value. New issue TIPS have a factor of 1.0. In an inflationary period the factor will go up; in a deflationary period it will go down. As the principal value changes, so do the interest payments. At maturity, TIPS pay either the adjusted or the original issued principal, whichever is greater. In the illustration above, an investor would receive $1,070 at maturity.
Investment highlights
Principal and Interest Variability – Since interest payments and principal value are linked to CPI-U, they may fluctuate over the course of a TIPS life, making it hard to project future cash flows. Investors looking for predictable cash flows should not rely on TIPS. However, including these bonds in a portfolio can be part of a well-established diversification strategy**.
Capital Preservation – Backed by the full faith and credit of the U.S. Government, TIPS hold a high credit quality. The value of TIPS can fluctuate up or down with changes in interest rates. Investors who need to sell prior to maturity are exposed to market risk and their proceeds may be more or less than the original investment.
Breakeven Inflation Rate – Depending on the inflationary environment, when comparing bonds investors should evaluate the difference in yields between TIPS and nominal Treasury bonds. The difference in yield is known as the breakeven inflation rate.
For example, if a 10-year TIPS yields .25% and a 10-year nominal Treasury note yields 2.25%, then the breakeven inflation rate is 2.00%. If inflation is higher than 2.00% over the life of the bond, then TIPS should provide a higher total return than conventional Treasuries with the same maturity. One must note that, historically, breakeven rates have been around 2.50%, which is the average rate of inflation since the introduction of TIPS in the mid-1990s.
Deflation Can Cause Loss of Value – Periods of deflation could cause TIPS’ principal amount to fall below par ($1,000). This would have a negative effect on investors who sell TIPS in the secondary market after a deflationary period. In addition, TIPS purchased with a high adjusted principal can lose value if the inflation factor goes down in the future. To assure positive return of principal, investors are encouraged to purchase newly issued TIPS or those with an inflation factor of less than 1.0. Investors who hold TIPS until maturity will receive a minimum of par or the inflation adjusted principal, whichever is higher.
TIPS vs. Nominal Bonds – TIPS and nominal bonds behave differently when inflation changes. In times of increasing inflation, nominal bonds will become less attractive as their fixed interest payments lose purchasing power. As inflation declines, nominal bonds become more valuable on a real return basis. If inflation turns out to be less than anticipated, the total return on TIPS could be less than that on a comparable nominal Treasury bond.
Liquidity – Although the U.S. Treasury securities market is one of the largest and most liquid securities markets in the world, the secondary market for TIPS is not as active or liquid as the market for nominal Treasury securities. Less liquidity and fewer participants may result in wider spreads between bid and ask prices on TIPS than Treasuries.
Taxation – Semi-annual interest payments on TIPS are subject to federal income tax, just like payments on nominal Treasury securities. Increases in a TIPS principal value are also taxed as income in the year they occur, even though those increases are not realized until the TIPS are sold or mature. This is known as taxing “Phantom Income.” Conversely, decreases in the principal amount due to deflation can be used to offset taxable interest income. Investors hoping to avoid the tax liability of “Phantom Income,” should consider purchasing TIPS in a tax-deferred account. Investors are urged to consult with their own tax advisors prior to making any investment decisions with tax consequences.
Negative After-Tax Cash Flow – In periods of high inflation, for high-tax-bracket investors (if purchased in taxable accounts) TIPS may result in a negative after-tax cash flow as the increase in principal value will exceed the net coupon payments.
Changes In CPI-U – Investors must understand that current changes in consumer prices are not indicative of future movements. Moreover, the three-month lag in CPI data used to calculate the CPI-U index change may have an impact on TIPS values in the secondary market. This is especially important when swings in CPI-U are significant and rapid.
Note: The hypothetical examples provided are for illustrative purposes only and not intended to reflect the actual performance or offering of any security.
*Rate of inflation is based on the Referenced CPI-U, which has a three-month lag.
**Diversification does not ensure a profit or protect against a loss.
Investing involves risk and you may incur a profit or a loss. The value of fixed income securities fluctuates and investors may receive more or less than their original investments if sold prior to maturity. Bonds are subject to price change and availability. Investments in debt securities involve a variety of risks, including credit risk, interest rate risk, and liquidity risk. Investments in debt securities rated below investment grade (commonly referred to as “junk bonds”) may be subject to greater levels of credit and liquidity risk than investments in investment grade securities. Investors who own fixed income securities should be aware of the relationship between interest rates and the price of those securities. As a general rule, the price of a bond moves inversely to changes in interest rates. Past performance is no assurance of future results.
The information contained herein has been prepared from sources believed reliable but is not guaranteed by Raymond James & Associates, Inc. (RJA) and is not a complete summary or statement of all available data, nor is it to be construed as an offer to buy or sell any securities referred to herein. Additional information is available upon request.
Investment products are: not deposits, not FDIC/NCUA insured, not insured by any government agency, not bank guaranteed, subject to risk and may lose value.