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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I found formulas for the after-tax real returns on regular Treasury bonds and TIPS thanks to Shen Pu in his 1998 paper "Features and Risks of Treasury Inflation Protection Securities" at the Federal Reserve Bank of K.C.
The after-tax real return on a regular bond is:
(1-tax rate)x(nominal return) - inflation rate.
The after-tax real return on a TIPS is:
(1-tax rate)x(real return) - (tax rate)x(inflation rate).
Using the numbers from my earlier post (nominal yield on regular bond = 3.6% and real yield on TIPS = 1.7%) and assuming your tax rate is 40%, if the inflation rate is 2% per year then the after-tax real return on the regular bond will be 0.16% and the after-tax real return on the TIPS will be 0.22%.
If the inflation rate is 5%, the after-tax real return on the regular bond will be -2.84% and the after-tax real return on the TIPS will be -0.98%.
As Pu says, "The tax code brings inflation risk back to indexed bonds ... ." TIPS are better than regular bonds, but are no panacea.
On July 22 the Wall Street Journal on-line shows a regular Treasury bond maturing in about 10 years (August 2019) with a nominal yield of about 3.6%. There is a TIPS maturing in about 10 years (July 2019) with a real yield of about 1.7%.
The nominal return on regular bond will be 3.6%. The nominal return on the TIPS will be 1.7% plus the inflation rate.
If the inflation rate is 2% per year, the real return on the regular bond will be 3.6% - 2% = 1.6% and the real return on the TIPS will be 1.7%. Not much difference, right?
If the inflation rate is 5% per year, the real return on the regular bond will be 3.6% - 5% = -1.4% and the real return on the TIPS will still be 1.7%. This is why TIPS are good protection against inflation.
In general, the real return on the regular bond will be 3.6% minus the inflation rate and the real return on the TIPS will be 1.7%. If you want to protect against “an extraordinarily high inflationary environment,” seriously consider buying TIPS.
Taxes complicate matters. If the inflation rate is moderate (or turns out to be approximately what people expected), regular bonds and TIPS will perform similarly. So if inflation is 2% per year, the after-tax real return on a regular bond will be similar to the after-tax real return on the TIPS.
The higher the inflation rate, the greater the damage to owners of regular bonds. Inflation in itself does not damage owners of TIPS, but it does create tax liabilities in your case. It is better to be compensated for extraordinarily high inflation and have to pay taxes on that, than not be compensated for inflation at all.
Anyone who buys TIPS outside of a tax-deferred account (who will have to pay taxes on the inflation adjustment) should make sure he or she has enough income to pay the taxes every year.
1. Compare substantial stimulus direct to all citizens vs satimulus given to banks and state governments.
2. Compare SBA or another private entity loaning/investing money in small business for expanding and start-ups.