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:
Yield on a 5 Year Conventional Treasury Bond
Treasury Nominal Yield = Real yield + expected inflation rate+inflation risk premium
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.