Treasury inflation-protected securities
are often called tips for short tips are
a type of government bond that accounts
for the fact that prices of goods and
services change over time they call this
inflation let's look a bit closer first
let's imagine that you bought $1,000 of
a typical 30 year Treasury bond and this
bond pays interest at a rate of 3% per
year this is called the nominal interest
rate nominal simply means the interest
rate you receive before inflation if you
adjust the interest rate by inflation
well they call this the real rate of
return so you can calculate the real
rate of return by simply taking our
three percent and subtracting inflation
as measured by the consumer price index
often called CPI so if the CPI shows
that inflation went up by let's say 2%
while our real rate of return for these
government bonds is just 1% but here's
where it gets interesting
to illustrate inflation movements here's
an actual chart of the CPI since the
1950s and yes inflation went a bit nuts
in the 70s and early 80s but you can see
that inflation hit almost 4% as recently
as 2011 and 5% in 2008 so what are the
alternatives this is where tips or
Treasury inflation-protected securities
step in you can buy tips for 5 10 or
even 30 year terms but let's stick with
our 30-year example so you invest the
same 1,000 dollars in tips and let's
imagine that this 30-year tips will pay
the same 3% as the regular bond it
wouldn't but we'll come back to that in
a minute so you pay the $1,000 this has
a few names it can be called it can be
called principle or face value or even
par value so the face value is your
month it's going to be paid back to you
when the bonds life ends in this case 30
years from now the 3 percent well this
is how much needs to be paid to you the
investor each year but government bonds
actually pay interest twice a year so
that 3% on the $1,000 is $30 per year
which is $15 every six months simple
enough
now this math is true for both regular
bonds and tips but what about inflation
so let's imagine that after the first
year inflation was 2% well what makes
tips you
Niek is that the face value in our case
the $1,000 is adjusted by the
inflationary so now our face value is
1020 dollars went by tips the interest
rate you received when the bond was
issued is locked but the interest
payments paid is a reflection of both
the fixed interest rate and the face
value of the bond that is adjusted with
inflation so now the 3% interest payment
the government owes you is 30 dollars
and 60 cents
divide that by 2 to account for the two
payments in a year and you get 15
dollars and 30 cents for this
semi-annual payment so what's the catch
well first off in our hypothetical
scenario we had both a traditional
30-year bond pay 3% and the Treasury
inflation-protected securities a percent
the only way this would really happen is
if inflation is expected to be 0% and
that's extraordinarily unlikely sticking
with more realistic numbers it's more
likely that inflation is expected to be
let's say 2% this would mean that the
traditional bond would pay an interest
rate of 3% while tips would pay an
interest rate of 1% this accounts the
expected inflation rate so with this in
mind our tips worth it while it depends
what's the average inflation rate for
the life of the bond if the inflation
rate over the 30 years averaged more
than 2% which is the initial spread
between the traditional and tips
well the tips would have a greater total
return if the average rate was less than
2% but the total return would be less
than traditional bonds if inflation was
exactly 2% well the total return would
be the same they call this 2% the
break-even rate now what about deflation
deflation is when the inflation rate is
negative all of deflation occurs the
bond value decreases so if the face
value was 1,000 dollars and then the
inflation rate was negative 1 percent
while the $1000 would fall by 1% or 10
dollars so now our face value is just
990 dollars and let's imagine that
deflation Speck around for a little
while and although you invested $1,000
at the start your tips term is coming to
an end
and currently they have a face value of
just 950 dollars what happens when you
go to get repaid your bonds face value
well the government will repay you the
full one thousand dollars the rule is
that you will be repaid the current face
value or par value par value is the
initial face value of the bond in our
case one thousand dollars so if your
face value had climbed all the way to
let's say twelve hundred dollars and the
deflation occurred knocking your face
value down to let's say 1150 well you
will be repaid the 1150 since that is
higher than the original par value and
for our final point let's take a quick
look at taxes with either tips or
traditional bonds your interest payments
every six months are subject to federal
income tax but with tips the adjustment
to the face value due to inflation is
also subject to tax which means that if
inflation was the original 2% we
mentioned and our $1000 face value was
adjusted higher by that 2% giving us a
$20.00 gain well will be taxed on that
$20.00 gain even though we will not be
given the $20.00 until the end of the
bonds life they call this phantom income
if deflation occurs while our phantom
losses can now be used to offset our
taxes if you have any questions about
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