Since 1997 the Treasury has offered “inflation-proof” bonds in maturities ranging from five to 20 years. These provide the opportunity for investors to lock in a given real (or inflation-adjusted) rate of return on Treasuries. A new Research Reports article by economist Philip R. Murray offers a look at how they work and how their rates of return have compared to conventional Treasury securities.
Treasury Inflation-Protected Securities (TIPS) are inflation-indexed bonds. Twice a year the U.S. Treasury adjusts the principal and the interest according to recent changes in the Consumer Price Index (CPI). In this way TIPS explicitly compensate their owners for whatever the rate of price inflation turns out to be. The table below shows how the Treasury adjusts principal and interest on TIPS. (To keep things simple, the example posits a single inflationary adjustment each year, rather than the twice-a-year calculation the Treasury actually uses.)
Table 1: Adjustment of Principal and Interest on a TIPS | Year | Price inflation rate | Adjusted principal | Interest payment | 1 | 3.3% | $1,033.00 | $20.66 | 2 | 3.5% | $1,069.16 | $21.38 | 3 | 2.5% | $1,095.89 | $21.92 | 4 | 1.5% | $1,112.33 | $22.25 | 5 | -1.0% | $1,101.21 | $22.02 | Assumptions: The original principal value of the TIPS is $1000 and the coupon rate on the TIPS is 2 percent. |
Assume the original face value of the bond is $1,000, the coupon rate is 2 percent, and the maturity is 5 years. In year 1 of the table, price inflation is 3.3 percent so the Treasury increases the principal to (1+3.3%)×$1,000 = $1,033 and makes an interest payment of 2%×$1,033 = $20.66. If the rate of price inflation falls, as in years 3 and 4 of the table, the Treasury still increases the principal and interest payment, though by smaller amounts. Note that owners of TIPS are not really any wealthier when the Treasury increases principal and interest payments. The adjustments merely compensate owners of TIPS for the reduced purchasing power of the dollar. In the event of price deflation (a fall in the general price level), the Treasury will reduce the principal and interest payment. Year 5 of Table 1 shows what happens when price inflation is -1.0 percent: the Treasury reduces the principal to [1+(-1.0%)]×$1,112.33 = $1,101.21 and makes an interest payment of 2%×$1,101.21 = $22.02.
Even if there is a Japanese-style sustained price deflation, however, the Treasury will return no less than $1,000 when the TIPS matures. This feature in effect puts a floor under the redemption value of the bonds at maturity.
One thing the table does not show: Owners of TIPS have to pay federal (though not state or local) income tax on the interest they earn and the adjustment to principal. For this reason, TIPS are typically better suited for a tax-deferred account such as an Individual Retirement Account (IRA) or 401(k) plan. For information on details and specifics, including how to buy TIPS, see the Treasury’s website (www.treasurydirect.gov).
Does all this mean that nominal returns on TIPS are necessarily greater than on conventional T-bonds? Not necessarily. Instead the answer depends on whether actual inflation exceeds the rate of inflation the market expects when the bonds are issued This commentary is based on a longer article by Philip R. Murray which explains how to buy low-risk government bonds that lock in a predictable real rate of return in the latest issue of Research Reports, available free to AIER subscribers or $2 for non-members. Also in this issue: - A Collapse Made in Washington
The conventional wisdom is that American families are drowning in credit card debt. But closer analysis reveals another story. Credit card debt is neither as widespread nor as large as commonly thought.
by Polina Vlasenko Research Fellow
- Ask the Expert: Credits for Green Autos
Tax specialist and car enthusiast Kevin McGrath outlines the 2009 tax credits for fuel-efficient vehicles.
by Kevin McGrath
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