Radical Guide to Bonds: A Quick Introduction to Treasury Inflation-Protected Bonds (TIPs)

TIPs are a different animal. 

When they first appeared in Treasury auctions, in 1997, TIPs became available for retail investors.  Both the interest and principal adjust with inflation.  As an inflation hedge to other bonds and equities ---which typically underperform in inflationary periods--- TIPs make good sense. 

TIPs work because deflation is rare.  The last time the CPI (a measure of consumer inflation) decreased over a 5-year period was more than 50 years ago.  Inflation is the norm, where most economists peg the historic rate of inflation to be around 3.0% -3.5% annually.

TIPs are aimed at retail buy-and-hold investors for their 401(K), Keogh, IRA, or other tax deferred accounts.  These investors park their TIPs.  They do not create much volatility in the market by buying and selling them.

Keep in mind that tax deferring accounts hold them for a reason.  Mechanically, a TIP’s principal balance is adjusted for inflation (usually twice a year).  A TIP’s interest payment is the fixed coupon applied to the inflation-adjusted balance (again, usually twice a year). 

In all, a higher principal balance means a higher interest payment.  The investor, in turn, faces increasing taxes on TIPs -- a tax on the additional amount of inflation-adjusted principal and on the additional interest itself.

We need to add some cautionary notes on TIPs.  These points are not the ones you often see. 

  • What the Treasury giveth, the Treasury can taketh away.  TIPs are adjusted according to a non-seasonally-adjusted measure of urban inflation called the CPI-U.  Go to the Bureau of Public Debt website and read the following statement:   “If, while an inflation-indexed security is outstanding, the CPI is…in the judgment of the Secretary [of the Treasury]… altered in a manner materially adverse to the interests of an investor in the security…Treasury will…substitute an appropriate index.” 

What all that means is vague.  How would the Secretary know what the interests of the investor are?  Would it be the interests of a long or short investor in TIPs?

As a TIPs investor, the Treasury pays you for actual, realized inflation.  Low inflation is a budgetary help.  Moreover, as the issuer of TIPs, the Treasury controls the inflation index used to determine how much it pays its investors.   

The Treasury may --- just may --- save real money by swapping to a lower-cost inflation index.  Can you trust the Treasury?  Can you trust any issuer completely? 

Consider another large issuer, Sears.  In 2003, Sears riled the retail bond markets by calling over $10 billion of its bonds.  Buried deep in one of its prospectuses, Sears had inserted language to call its bonds upon a drop the receivables on its books.  Sears sold a large chunk of its credit card portfolio.  So, because of this self-induced action, the receivables dropped and Sears exercised its call option. 

Suddenly, investors who had purchased the Sears bonds at a premium were handed their money back at par.  The investor losses were large and widespread. 

You can never be too sure with issuers.

  • Whose inflation is it?  From your perspective, real inflation erodes your purchasing power in the future.  Your purchasing power is determined by what you consume.  So, as an investor in longer-dated TIPs, you are protecting your purchasing power out ten, twenty or thirty years from today.  Your consumption expenses --- then, not now--- will likely be heavily weighted toward education and healthcare. 

The CPI-U is designed as a fixed-weight inflation index.  The weights change about once a decade.  Even though education and health care costs have escalated in the last decade, they have relatively low weights in the CPI-U.  In fact, for households on the two coasts or in any urban area, the CPI-U underweights many significant cost items. 

Chain-weighted inflation measures are superior measures to CPI-U.  The chain-weighted measures change with consumption patterns.  For instance, because more laptops are purchased today, computer equipment costs have a higher weight in the index than a decade ago. 

Even better inflation measures are regional or sector ones.  Maybe one day we’ll see TIPs indexed to sector inflation measures.  TIPs tied to a healthcare cost index would be big hit with a retiree population.

For now, TIPs are tied to an inflation measure that may not be relevant for many TIPs investors.

  • Buy TIPs in the auction and stay short.  You want to buy TIPs where the level of expected inflation is the greatest.  That inflation upsurge is not necessarily far out in the future.  In any event, as we saw, longer-term TIPs may not protect you from your inflation! 

A better strategy is to buy TIPs at the shorter end.  That way, you get some inflation protection and you don’t pick up too much price volatility.

Ok, so those are our thoughts on TIPs.  Keep an eye out for the TIPs auctions, too.  They may be a good entry point to the market… and you pay only that flat ticket charge in an auction through your online bond broker.

Next, we turn to another important segment of the retail bond markets: corporate bonds.

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June 3, 2005 | Permalink

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