Treasury Inflation-Protected Securities, or TIPS, are U.S. government bonds that are indexed to inflation. TIPS provide protection against inflation (or the rise in price of goods and services), intended to protect investors from a decline in the purchasing power of their money. If inflation rises or increases, the principal value of TIPS adjusts upward to reflect that inflation increase. Conversely, if there is deflation, the opposite occurs and the principal value adjusts downward to reflect that deflation. Please note that we are talking about inflation and deflation as measured by the Consumer Price Index (CPI). Inflation results in a rise in the CPI, whereas deflation results in a decline in the CPI. Importantly, the initial interest rate or coupon of the TIPS will not change, but the principal amount will change, resulting in higher or lower interest or coupon income (fixed interest or coupon rate multiplied by the adjusted principal value). The inflation adjustment to the principal is cumulative.
TIPS pay interest two times per year, at a fixed rate, i.e., the interest rate does not change, but the interest payment varies with the adjusted principal value of the bond. The fixed rate is applied to the adjusted principal. So, the amount of interest could be higher if the adjusted principal increases because of an inflation change, or could be lower if the adjusted principal decreases due to a deflation adjustment. Upon maturity of TIPS, the investor receives the adjusted principal or the original principal, whichever is greater (even if a deflation adjustment caused the adjusted principal balance to fall below the original principal).
So let’s look at how adjustments work under both an inflation change and a deflation change. Using an example of an investor purchasing $1,000 in TIPS at the beginning of a year with a coupon rate of say 2%, if CPI measures no inflation, the investor will receive $20 in coupon payments for that year. Assuming inflation rises by 2%, the $1,000 principal of the TIPS would adjust upward by $20 to $1020 (2% inflation x $1,000 principal) and the coupon payments would total $20.40 for that year. If deflation materialized, say to the tune of -4%, the $1,000 principal of the TIPS would adjust downward by $400 to $960 (-4% deflation x $1,000 principal) and the coupon payments would total $19.20 for that year. Even with deflation, at maturity, the holder will receive the greater of the adjusted principal of the TIPS or the original principal. The investor is never at risk of losing the original principal if held to maturity. So, in the example of the 4% deflation adjustment, resulting in the adjusted principal of $960, the investor would receive $1000 principal upon maturity. Please note, however, that if sold before maturity in the secondary market, there is the possibility to receive less than the initial principal.
CPI inflation adjustments are made semiannually and the inflation adjustments of a TIPS bond are considered taxable income by the IRS even though an investor would not see that money until the bond is sold or it reaches maturity (please note that TIPS are exempt from state and local income taxes, but are taxable at the Federal level). Holding TIPS bonds in a retirement account could help to minimize the tax impact.
The difference or spread between the yield of a TIPS bond and the yield of a traditional Treasury bond of comparable maturity is known as the breakeven rate. This breakeven rate represents the inflation expectation or inflation outlook over the life of the bond. Accordingly, the yield on a TIPS bond is equal to the traditional Treasury bond yield minus the expected inflation rate. But note that the spread between TIPS and traditional Treasury bonds is not a faultless predictor of inflation, as both instruments are subject to market forces and investor emotions. If the CPI were to average more than that spread or difference over the life of the bond, then the TIPS would deliver a higher total return than the traditional Treasury bond. However, if expected high inflation fails to materialize, then the TIPS could underperform traditional Treasury bonds.
When the traditional Treasury bond is trading at a yield below the expected inflation rate, the yield on a TIPS bond declines into negative territory. A phenomenon known as “the flight to safety” or “the flight to quality” explains why investors sometimes accept negative TIPS or any other treasury yields. In times of marked economic uncertainty, investors’ fear of losing their investments frequently overwhelms their desire for tolerable returns.
Considering the recent escalation of inflation pressures on goods and services and the related mounting consumer concerns, as well as the likelihood of questions and interest that may arise around these securities, we thought it was important to provide an overview of TIPS. Circa Capital currently has no bond portfolio exposure to TIPS and we do not anticipate that changing over the near-term. Negative yields, heightened interest rate risk and concerns around accurately forecasting inflation rate adjustments in the future supports our preference of utilizing traditional Treasury bonds (via Vanguard ETFs) over TIPS. We will continue to monitor inflation and its impact on TIPS and their performance relative to traditional Treasury bonds to determine if allocation change/modification is warranted.
~ James Callahan, CFA