Since I and some other METARs are interested in buying TIPS it would be good to know how to evaluate them.
Every TIPS has a fixed interest rate. The interest rate is applied to the principal, which is adjusted to inflation. If inflation rises both the principal and the interest will rise together by the same factor. TIPS will adjust their
principal based on changes on U.S. Consumer Price Index
(CPI) and pay out a fixed coupon rate on the principal. As
the size of the principal is adjusted, the coupon will also
change, increasing and decreasing with changes in CPI.
When TIPS principal values are adjusted upwards, the Internal Revenue Service (IRS) considers this change in value as income paid to the investor and is taxed. However, investors do not receive the cash flow from this income until the maturity of the bond, hence the term ‘phantom income’. (ref. iShares TIPS brochure.)
This article explains some drawbacks of TIPS, including the fact that the TIPS price can fall (like any bond) if interest rates rise. Investors who bought TIPS between 2020 and 2022, when the yield was negative, have lost a lot of value since the TIPS yields have risen with the Federal Reserve’s policies to combat inflation.
There is a lag between the inflation announcement and its
impact on the price of the TIPS. The inflation
adjustment is based on changes in CPI-U.
Technically, the inflation adjustment to TIPS is
based on an index ratio for each individual bond,
which is set at 100 at issuance. The particular
index value for an individual TIPS is known as its Reference CPI-U. However, there is a three month lag between the time when the CPI-U value is published and when that value affects the Reference CPI-U for the inflation adjustment of a TIPS bond.
For example, the Reference CPI-U for the
first day of any calendar month is the CPI-U
published for the third preceding calendar
month. Thus, the Reference CPI-U applicable
to April 1 in any calendar year is the CPI-U
published for January. This lag between the
inflation prints and the impact on the price of
a TIPS can be confusing, since larger increases
in inflation do not affect the principal amount
of the TIPS for three months. In the secondary
market, this lag can affect the trading price of
TIPS as the market anticipates the future
changes in the CPI-U.
To calculate the inflation-adjusted interest you will get, near the time your interest payment is due, follow these steps:
- Locate your TIPS on the TIPS Inflation Index Ratios page.
- Follow the link and locate the Index Ratio that corresponds to the interest payment date for your security.
- Multiply your original principal amount by the Index Ratio. (this is your inflation-adjusted principal).
- Now, multiply your inflation-adjusted principal by half the stated interest (coupon) rate on your security.
The resulting number is your semi-annual interest payment.
- You have $1,000 invested in a 5-year TIPS with an interest rate of 0.125%.
You will get an interest payment next week and want to know how much it will be.
- When you look up the Index Ratio for your TIPS, you see it is 1.01165.
Multiplying your $1,000 by 1.01165, you get your adjusted principal: $1,011.65.
- For this six-month payment, you get half of 0.125% (your annual interest rate), which is 0.0625%.
- Turn the percent into a decimal by moving the decimal point two places to the left: 0.000625.
- Now, multiply the adjusted principal by the half-year interest rate: In this example, multiplying $1,011.65 times 0.000625 gives you your expected interest payment: $0.63. [end quote]
When buying a TIPS on the secondary market, the TIPS will have a price and an “adjusted price.” The adjusted price is the actual price that includes the increase in the principal of the TIPS since it was issued. If held to maturity, all the increase in principal will belong to the buyer of the TIPS. The “adjusted price” is always higher than the “price” which includes only the coupon but not the increase in principal. The YTM is based on the coupon and the “price.”
Let’s look at CUSIP 9128284H0, UNITED STATES TREAS NTS TIPS 0.62500% 04/15/2023, which is a secondary-market TIPS listed on Fidelity. The issue date was 04/30/2018 so it is a 5-year TIPS. At this moment, its Ask YTM is 3.90% in minimum order of 100. Its Depth of Book lists 3 other quantity and Ask Yields, including one which allows a purchase of a single bond (1 = $1,000) with an Ask Yield of 3.777%.
|[Dated Date Reference CPI] 248.39153
|[Daily Reference CPI] 297.62361
|[Reference CPI Settlement] 297.62361
|[Inflation Factor] 1.19820
|[Historical Inflation Factor] 1.19789
The “Dated Date” is the date on which coupon interest will begin to accrue. Like other Treasuries, TIPS can have both an original and reissue date for the same CUSIP.
The Inflation Factor is calculated by dividing the latest Reference CPI by the Reference CPI on the Dated Date of the bond. The factor is the number the face value of the bond is multiplied by to calculate the adjusted principal.
This bond pays interest semiannually. Since it matures on 4/15/2023, its next interest payment will be its last.
Let’s say we have one $1,000 bond. What will this final interest payment be? What principal will be returned at maturity?
The adjusted principal today will be $1,000 times 1.19820 (the inflation factor) = $1,198.20. We don’t know what the final principal of the bond will be because we don’t know what the inflation factor will be on the date it matures.
To get the interest payment, we will look up the Index Ratio on TIPS/CPI Data — TreasuryDirect.
The index ratio for 9128284H0 maturing 4/15/2023 (@MarkR note that this is a reissue and the original TIPS with the same CUSIP will mature on 1/15/2023) is 1.19973.
- Multiply your original principal amount by the Index Ratio.
This is your inflation-adjusted principal. ($1,000 X 1.19973 = $1,199.73)
- Next, multiply your inflation-adjusted principal by half the stated interest (coupon) rate on your security. $1,199.73 X (0.625%/2) = $3.75.
Now, this is a very small amount of interest! But remember that the price paid for the bond was discounted so the actual YTM is higher than 0.625%. Also, the principal of the TIPS will be higher due to inflation.
Investors don’t buy TIPS to make a huge amount of money. TIPS are a way to maintain the value of cash (plus a small interest rate) during inflationary times. (Professional traders do trade bonds to make money from interest rate swings, but I’m not in that class.)
TIPS do lose value if interest rates rise. This is different from I-Bonds, which always return full par value regardless of prevailing interest rates.
Currently, TIPS yields are higher than they have been in over 10 years. Anyone who expects inflation to be higher than predicted by the market would do better to buy TIPS than Treasuries.