Following my last post there is an interesting story Bloomberg today about how many Americans are now struggling to survive...even the middle classes are suffering and finding it hard to meet their bills Link 1. The US government has also published some useful stats from the census data Link2.  To me it is amazing that the poverty rate in 2012 at 15% is actually higher than it was in 1967 when it was 14.2%. The main highlights of the census report are:

.• Median household money income for the nation was $51,000 in 2012, not statistically different from 2011, in real terms
.• The 2012 official poverty rate for the nation was 15.0 percent and there were 46.5 million people in poverty, not statistically different from last year.
•The percentage of people without health insurance coverage decreased in 2012 to 15.4 percent from 15.7 percent in 2011. The number of uninsured was not statistically different from 2011, at 48.0 million.

Came across this interesting article published by William Domhoff Link1
based on research published by Edward Wolff of New York University Link2 -seems that the top 1 % are having a great time measured by both income and wealth. The mean household income for the top 1% is $1,318,200 for the bottom 40% it is $17,300. Meanwhile in terms of wealth the top 1% have mean household wealth of $16,439,400 while the bottom 40% have negative net worth of -$10,600. To me this is nuts, so few having so much while so many have so little does not help society. The control of assets and wealth  by so few means we are in danger of creating societies where the "rentier" class end up spending most of their time and effort protecting their income wealth from the vast majority of society, that actually create the income and wealth. It seems to me that at some point the vast majority are going to rebel against the system and elect governments that focus on income and wealth redistribution.

Table Income, net worth, and financial worth in the U.S. by percentile, in 2010 dollars

I often get asked questions by my students about Treasury Inflation Protected Securities and so here goes !

Treasury Inflation Protected Securities (TIPS) How do they work ?
A Treasury Inflation Protected Security is protected against inflation as measured by the changes in the consumer price index (CPI). The best way to illustrate how they work is to use a simple numerical example:Let’s assume a 5 Year TIPS is issued with a face value (F) of $1,000 and a fixed annual coupon rate of C = 2% (in practice, the coupon is paid in semi-annual payments but we shall ignore this).

The trick with TIPS is that the principal to be repaid in year 5 and the annual interest rate payable are both adjusted in line with change in the Consumer Price Index. This means that the real rate of return to the investors is constant at the fixed interest at the time of issue of 2%.

 

                                                                                        
                                                            Coupon Payment                                  Real Rate
           Inflation    Adjusted               based on Adjusted            Return       of Return
Year    Rate      Par Value (APV)     Par Value (0.02 x (APV)]   per annum   per annum

  0         0                 $1000                               -                                    -                      -

  1         4%              $1040                          $20.80                           6.08%               2%

  2         5%              $1092                          $21.84                           7.10%               2%

  3         6%              $1157.52                     $23.15                           8.12%               2%

  4         4%              $1203.82                     $24.08                           6.08%               2%

  5         2%              $1227.90                     $24.56                           4.04%               2%


Return per annum  = R is calculated as:

Principal this year – principal last year + coupon this year
                                    Principal last year

Real rate of Return is calculated as:

   1 + Return per annum        -   1
1 + inflation rate per annum

Note 1 in the above calculations inflation at 4% is 0.04, 5% is 0.05, 6% is 0.06, 4% is 0.04 and 2% is 0.03. Similar reasoning is applied to rates of return and real rates of return.

As such, Treasury Inflation Protected Securities offer a fixed real rate of return assuming that (i) there no taxes (ii) ignoring  the reinvestment of coupons and (ii) assuming no change in the real rate of interest

Note 2 TIPS also provide some deflation protection to the principal (but not to the coupon payments). If, at maturity, consumer prices have fallen e.g. 5% lower than when they started so much that the inflation-adjusted principal would be below par ($950), the Treasury will repay the principal at par value ($1000). As such TIPS can be said to provide a “deflation floor.”

The information content of yield on TIPS and conventional Treasury bonds
To understand the differences in yields between TIPS and conventional bonds, it’s useful to review the components of the nominal yields for both:

Equation 1:

Yield on a 5 Year Conventional Treasury Bond

Treasury Nominal Yield = Real yield + expected inflation rate+inflation risk premium

Equation 2:

Yield on a Treasury Inflation Protected Security with 5 years left to Maturity

TIPS Nominal Yield = Real yield + actual inflation rate

If we ignore the risk premium (i.e. assume the risk premium to be zero) then:

5 Year Treasury  - 5 Year TIPS coupon yield    = Expected Rate
nominal yield              (i.e real yield)                      of Inflation

For example, an investor who, over say 5 years is seeking a real return of 2%, expecting inflation to average 4%, and demanding an inflation risk premium of 0.5% would according to equation 1 buy a 5 year to maturity conventional Treasury yielding 6.5%.

The same investor should also be willing to buy a comparable 5 year yield to maturity TIPS with a coupon yield of 2.00%, because it would provide a 2.00% real return plus an adjustment to match whatever the inflation rate turns out to be.  

If we take the Treasury Nominal Yield of 6.5% and deduct the 2% real return from the 5 Year TIPS we obtain 4.5 % which is the expected rate of inflation plus the inflation risk premium.

As you can see, the yields will differ depending on both the size of the inflation risk premium and the gap between expected inflation and actual inflation

Note 3 in the very short run eg up to 2 years the expected inflation and actual inflation will not usually differ very much. As a result, the size of the inflation risk premium will be the main factor in the yield differences between conventional Treasury bonds and TIPS. The size of the inflation risk premium will be mainly determined by the level of investor uncertainty about inflation. A suitable proxy inflation uncertainty is the volatility of the actual inflation rate.

Sad to hear of the death of Nelson Mandela a truly inspirational person. I spent 6 very happy months in South Africa in 2004 and learnt a lot about its history, its exceptional beauty and its huge social and economic problems. I also learnt a lot about his role in its history and visited Robben Island where he was imprisoned.The country and I think the world will rightly spend a lot of time thinking about his huge contribution and example to the human race. Such leaders are very rare species indeed. South Africa was fortunate to have him.