A Quick and Dirty look at TIPS
VHF members should know when we talk about “cash” we examine not only overnight instruments, but the entire fixed income area, including Treasury Inflation Protected Securities (TIPS) or as they’re sometimes called - Treasury Inflation-Indexed Securities (TIIS). For the sake of brevity, we’ll identify the entire class as “TIPS”. If you are an individual investor, you have few choices your savings account or brokerage money market. If you have a margin account you have more choices like T- Bills, Notes, Bonds, or even 5 - 30 year TIPS. Because TIPS can theoretically trade at a discount to par prior to maturity, you may want to use TIPS only if you can hold them to maturity. The Commitment by the US Treasury
The Treasury is committed to developing the market for Treasury Inflation-Indexed Securities. These types of fixed income instruments offer investors a unique asset class that make a distinctive contribution to any diversified portfolio. TIPS also allow Treasury to broaden its investor base and diversify its funding risks. Benefits to Investors of a Unique Asset Class
1. Unique asset class (dollar-denominated, inflation-indexed, full faith and credit of the United States)
- Virtually risk-free asset for investors focused on future real purchasing power of their savings.
- Low volatility and attractive returns
- Closer match to inflation than real estate, commodities, or other real assets
2. Market Big and Growing
- Almost $150 billion TIPS outstanding, and about $350 billion inflation-indexed securities outstanding worldwide.
- Liquidity in the TIPS market is improving, with daily trading volume having almost doubled in the past year ( to 2003).
As an integral part of Treasury's funding strategy, the expanded auction schedule for 10-year TIPS notes and increased issuance as follows:
- 10-year TIPS notes make up over a quarter of Treasury's 10-year note issuance.
Smaller investors should note that Treasury offers Series I inflation-indexed savings bonds. - Smaller investors should note that Treasury offers Series I inflation-indexed savings bonds.
- The Investment Environment
In this environment, with the Fed Funds rate at 1.25 it is difficult for those with income or preservation of principal goals to keep up with the rate of inflation. Saving accounts and brokerage money market rates are currently paying 1.80% or lower not counting fees. But still a plus when compared to the equity market the last three years.
TIPS are designed to protect the buy buyer from inflation. TIPS are backed by the full faith and credit of the US Government. Like other US T-Bills, Notes, and Bonds, TIPS are a benchmark of the risk free rate. In an interest rate environment with Fed funds at 1.25%, 90 day T- Bills at 1.08%, 10-year T-Notes at 3.42%, 30-year Bonds at 4.41%, all at or near historical lows.
TIPS are issued in 5, 10, and 30-year maturities. VHF prefers the 10-year TIPS due to the liquidity and importance of the US 10-year Note. For example, mortgage rates trade off a spread over the 10-year. TIPS have an embedded option. In other words at maturity you are guaranteed par (100). What really makes them cool is the embedded call on inflation. As inflation tracks the Consumer Price Index (CPI), the notes principal increases by the rate of inflation. This is a great play for both conservative and aggressive investors in this low rate environment.
If auctioned on the same day at the same time and price what is the difference between the 10-year US T-note and the TIPS? Currently the yields are 3.42%, 1.75% respectively. Assuming the market is trading efficiently the change in yield 3.42 – 1.75 = 1.67 is the implied rate of inflation. Or you could look at 1.67 as the cost of the inflation call embedded in the TIPS.
Implied Option
Although we are currently in a highly deflationary environment, TIPS are a plus due to their protection against the future reemergence of inflation. Let’s test it by running a couple scenarios of long TIPS positions bought at original auction. If yields drop, the price rises on all notes and bonds, creating a trading opportunity to sell. Keep in mind, if rates go to zero, there is nowhere to reinvest your profits, assuming you want the identical risk free rate. Had you bought the 10-year TIPS (3% 7/15/2012) at last July’s auction at par, you would have received one coupon payment and be currently marked at 110-16 /32. As of 5/28/2003 a 10.5% gain in less than a year – SELL! Approximately, 12.6% annual return (10.5% * 12/10 = 12.6%). If you decide to hold, you have downside risk. Your “implied put option” has 100 strike at maturity. And you will be subject to tax on the gain on principal just like with zero coupon notes. If rates rise, your principal will be at risk to the extent the increase in the CPI is less than the increase in the nominal interest rate.
For those who buy and hold to maturity the Treasury Direct program is ideal. You can buy them through your broker for a small fee or open an account with the department of Treasury. It’s free for accounts less than 100,000 (I think). Then purchase TIPS at auction directly from the Treasury without commissions. If you’re thinking about trading the TIPS, buying via a broker or bank at the original auction (not a reopening) is recommended for custody reasons. Yes, you will pay a commission but the sale of the TIPS is effortless, a big plus. But if you trade TIPS make sure you really understand them. For exact security specifications and how to set up an account, please visit the Treasury website.
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