How TIPS work

Have a question about your personal investments? No matter how simple or complex, you can ask it here.
Post Reply
Bubbagump
Posts: 61
Joined: Thu May 09, 2013 11:42 pm

How TIPS work

Post by Bubbagump » Mon Oct 13, 2014 9:33 pm

So I understand TIPs adjust according to inflation and the CPI. What I don't follow is do they pay a yield beyond this? Are they just Treasuries with variable inflation protection (versus an estimate of inflation built in). Or are they more like a money market with inflation protection ie: they are designed to protect purchasing power and nothing else?

User avatar
Phineas J. Whoopee
Posts: 6811
Joined: Sun Dec 18, 2011 6:18 pm

Re: How TIPS work

Post by Phineas J. Whoopee » Mon Oct 13, 2014 9:51 pm

Bubbagump wrote:So I understand TIPs adjust according to inflation and the CPI. What I don't follow is do they pay a yield beyond this? Are they just Treasuries with variable inflation protection (versus an estimate of inflation built in). Or are they more like a money market with inflation protection ie: they are designed to protect purchasing power and nothing else?

Hi Bubbagump,

Let's talk about how they're designed to work, but first give a little shrift, preferably long not short, to today. At the moment interest rates are perverse, and some TIPS have negative real rates. That's real confusing. The rest of this post assumes a more normal interest rate situation, even though all the math will work out the same.

We'll talk about individual Treasury Inflation Protected Securities, not a TIPS fund. The fund works just like a rolling ladder of securities, but I think it's easier to answer your question if we think about just one TIPS.

Looking up today's 10-year real yield it's 0.29%.

So, what happens, setting aside a small complication at issuance, is the treasury auctions off, for example, $10 billion of 10-year TIPS. I won't go into the auction details - if you're interested ask and we can talk about them. We'll pretend the 0.29% is in fact the result of a treasury auction today, although really it's the result of an ongoing, continuous auction in the secondary market.

The TIPS has a (simplifying here) $1000 face value at issuance, and a 0.29% real interest rate.

The Bureau of Labor Statistics calculates the Consumer Price Index using its published methodology and data.

Each day the treasury adjusts the face value of the TIPS, up or down, based on previously-calculated CPI, positive or negative, as published by BLS.

Twice a year, just like other treasuries, there's an interest payment, this time under our simplified assumptions 0.29% annualized, so half of that, 0.145%, of the then-adjusted face value.

That means both the principal and the interest are being adjusted for CPI: the principal directly, and the interest as a percentage of the adjusted principal.

The inflation adjustment is built in and will continue. The interest above that (outside of perverse situations like what we've recently been in) is calculated on the adjusted principal.

The interest above inflation is set by the initial auction. It's continually reset by the ongoing secondary market auction.

These days the interest above inflation, the real yield, has been pretty low, sometimes slightly negative, so it's not so far off from what you asked about, a money market instrument with inflation protection. That isn't the long-term setup. It's just a result of our current low-real-yield environment. There have been times in the past where 10-year TIPS were sold with real yields around 3% above inflation.

Even if there has been deflation, negative inflation, so much during the TIPS term that its adjusted face value is below its issued price, it never is redeemed below there. A $1000 TIPS, if at maturity has an adjusted value of $800, will still pay out $1000. That's an unlikely scenario, but it's there and the market participants take account of it.

The overall setup isn't for just-inflation-and-nothing-else, but it isn't far off from there today.

PJW

Bubbagump
Posts: 61
Joined: Thu May 09, 2013 11:42 pm

Re: How TIPS work

Post by Bubbagump » Mon Oct 13, 2014 10:12 pm

So there is a real yield in addition to the inflation adjustment? So it seems my first though was correct. TIPS are just Treasuries that adjust for inflation dynamically? As opposed to a built in static inflation estimate at time of purchase? Or said another way.... A yield on a nominal 10 year treasury is say 2.79%. If I buy a 10 year TIPS on the same day as that nominal Treasury with a real yield of 0.79% (and inflation is magically exactly 2% for 10 years and interest rates magically don't change for the same 10 years).... Will both bonds pay out the same amount? Does the real yields on TIPS relate to yields on nominal Treasuries in the way I am thinking they do?

User avatar
#Cruncher
Posts: 2447
Joined: Fri May 14, 2010 2:33 am
Location: New York City
Contact:

Re: How TIPS work

Post by #Cruncher » Tue Oct 14, 2014 12:47 am

Bubbagump wrote:A yield on a nominal 10 year treasury is say 2.79%. If I buy a 10 year TIPS on the same day as that nominal Treasury with a real yield of 0.79% (and inflation is magically exactly 2% for 10 years and interest rates magically don't change for the same 10 years).... Will both bonds pay out the same amount?
You are correct, Bubba, except for a couple of points:
  1. Interest rates need not stay the same if both bonds are held to maturity.
  2. The bonds won't necessarily "pay out the same amount", but their nominal yields to maturity will be the same.
This equivalence when the CPI runs at the "breakeven rate" also applies to nominal Treasuries and TIPS when the TIPS yield is negative. For instance there is a 0.875% nominal Treasury and a 0.125% TIPS both maturing on 4/15/2017. The nominal is currently priced about 100.5% and the TIPS about 101.75%. (See WSJ Quotes 10/09/2014 Nominal Treasuries and TIPS.) The corresponding yields to maturity (YTM) are 0.673% for the nominal Treasury and -0.569% for the TIPS.

The 2nd column of the following table shows the cash flow and YTM for the nominal Treasury over its remaining life. The 3rd column shows them for the TIPS in real terms. The 5th column shows them for the TIPS in nominal terms when adjusted for a CPI change (in the 4th column) equal to the breakeven rate. [ 1 ]

Code: Select all

   Date     Nominal        TIPS         CPI      Adj TIPS 
--------   ---------    ---------    --------   ----------
10/15/14  (10,050.00)  (10,175.00)   1.000000  (10,175.00)
04/15/15       43.75         6.25    1.006228        6.29
10/15/15       43.75         6.25    1.012494        6.33
04/15/16       43.75         6.25    1.018800        6.37
10/15/16       43.75         6.25    1.025145        6.41
04/15/17   10,043.75    10,006.25    1.031529   10,321.74
           ---------    ---------               ---------
Net Amt       168.75      (143.75)                 172.13
IRR (6 mo)   0.3365%     (0.2845%)                0.3365% [ 2 ]
Annual YTM   0.6730%     (0.5690%)                0.6730% [ 3 ]
When the TIPS cash flow is adjusted for a CPI assumed to increase at the "breakeven rate", the YTM is the same as for the nominal Treasury, 0.673%.

  1. The precise "breakeven inflation rate" is 0.6228% per six month period and is computed as follows:

    Code: Select all

    0.6228% = (1 + 0.003365) / (1 - 0.002845) - 1
  2. This is computed with the Excel IRR function and represents the discount rate per six-month period that makes the cash flows net to zero.
  3. The annual YTM is double the Internal Rate of Return (IRR) per six month period. [ edit: added following ] It can also be calculated -- except for the adjusted TIPS case -- with a bond calculator like ficalc.com or with the Excel YIELD function. For example,

    Code: Select all

       0.6730% =YIELD( DATE( 2014, 10, 15 ), DATE( 2017, 4, 15 ), 0.875%, 100.5,  100, 2, 1 )
      -0.5690% =YIELD( DATE( 2014, 10, 15 ), DATE( 2017, 4, 15 ), 0.125%, 101.75, 100, 2, 1 )
    The adjusted TIPS case can only be calculated by doubling the 6-month Internal Rate of Return.
Last edited by #Cruncher on Tue Oct 14, 2014 9:10 am, edited 2 times in total.

User avatar
nisiprius
Advisory Board
Posts: 34639
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: How TIPS work

Post by nisiprius » Tue Oct 14, 2014 6:34 am

Bubbagump wrote:So there is a real yield in addition to the inflation adjustment? So it seems my first though was correct. TIPS are just Treasuries that adjust for inflation dynamically? As opposed to a built in static inflation estimate at time of purchase?
Yes, you've got it. The way I like to think of it is this. A European bond works just like a U.S. bond except that it's denominated in Euros. TIPS are just like any other Treasuries except that they are denominated in real dollars. That is, they are denominated in inflation-adjusted, constant-value dollars, instead of in fluctuating-real-value nominal dollars.

To put it another way around, if we think in real dollars:
--A European bond has extra risk compared to a U.S. bond because for a European investor, the dollar value of the Euro fluctuates.
--An ordinary Treasury bond has extra risk compared to a TIPS bond, because the value in real dollars--the purchasing power--fluctuates.

Jeremy Siegel says this in Stocks for the Long Run, 5th edition, p. 375
The only long-term risk-free assets are Treasury inflation-protected securities.*
Yes, it is just that simple.

(Although series I savings bonds, because of having no interest rate risk--no market fluctuations--are risk-free both in the long term AND the short term.)

Any talk of TIPS being risky is in the context of short-term market value fluctuation, and if what you care about is short-term market fluctuations, then certainly the behavior of TIPS is mysterious and risky--just like the short-term market behavior of any other security. And certainly, once you get down to technical details of how auctions work and such, TIPS are mysterious to me, but that's true of everything else about every investment when you start to look closely at it. How many investors know how to calculate the difference between the dirty price and the clean price of a bond? How many investors understood the issues of bond overvaluation in the early days of the PIMCO BOND ETF? Not me.

*(Siegel says this in order to make a different point, about the superiority of stocks, and uses TIPS as a measuring stick, not a recommended investment; however in 2004 he also put himself on record as saying "You know, I’ve been a fan of TIPS—I’ve written columns about TIPS. I certainly prefer those to the standard nominal bond, especially for people planning for retirement." He would probably say today that he only meant that in the context of year-2004 TIPS yields, which were higher than today.)
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

Bubbagump
Posts: 61
Joined: Thu May 09, 2013 11:42 pm

Re: How TIPS work

Post by Bubbagump » Tue Oct 14, 2014 11:30 am

This is all very enlightening as I had the impression that TIPS ONLY covered inflation... they essentially were an inflation adjusted constant dollar money market. Now the 50/50 TBM/TIPS folks make a whole lot more sense. TBM is ~60% Fed bonds... so at 50% TIPs to 50% TBM in your fixed income allocation, you get kinda closish (50% TIPS, 30% Nominal) to your federal bonds being 50/50 plus the added potential in corporate. Then, you have a hedge against inflation in TIPS and deflation in nominal. That said, 50/50 TIPs/TBM seems like an over weighting in TIPS. 40% TIPS to 60% TBM gets you closer to 50/50 TIPS/Nominal (40% TIPS to 37.2% nominal if we are splitting hairs). At the end of the day it comes down to a gamble in a way. We all sort of hope they underestimate inflation when pricing nominal bonds, but have TIPS to protect in case they royally screw up.

All this said, I'll probably end up with a heap in munis soon enough... so as far as a fixed income allocation. I may do something along the lines of 40% TIPs, 50% muni, 10% high yield to get a little corporate in there.... or say screw it all and just go full intermediate muni and put REITs in the tax advantaged space. High tax bracket tap dancing makes this harder than it needs to be at times.

User avatar
CWRadio
Posts: 300
Joined: Sat Feb 02, 2008 10:04 am
Location: In the Michigan ionosphere

Re: How TIPS work

Post by CWRadio » Tue Oct 14, 2014 11:50 am

Can you please explain what causes the NAV of Vanguard Short-Term Inflation-Protected Securities ETF (VTIP) and DFA Inflation-Protected Securities (DIPSX) to change each day. I have asked this question a few times but still have a problem understanding. Thanks Paul

Bubbagump
Posts: 61
Joined: Thu May 09, 2013 11:42 pm

Re: How TIPS work

Post by Bubbagump » Tue Oct 14, 2014 12:22 pm

Mostly this:

http://www.treasury.gov/resource-center ... =realyield

Keep in mind this stuff changes daily. Your bond price changes accordingly. So some subsection of the bonds in the fund lost NAV as yields went up assuming you had the ability to sell those specific bonds that day (there may be other bonds in the fund that didn't lose NAV, but the NAV losers out weight the NAV maintainers). The question is, do you care about NAV really (like you need the liquidity)? Or do you care about yield (you just want the income)? So long as you can sit on a bond fund long enough (see the average duration) all things come out in the wash. If you do care about liquidity (aka, don't want NAV to go down) you need to look to short term bonds at the expense of higher yields.

What really helped me was to understand bond ladders. Once you understand bond ladders you realize a bond fund is really just a huge bond ladder.

User avatar
Phineas J. Whoopee
Posts: 6811
Joined: Sun Dec 18, 2011 6:18 pm

Re: How TIPS work

Post by Phineas J. Whoopee » Tue Oct 14, 2014 1:51 pm

CWRadio wrote:Can you please explain what causes the NAV of Vanguard Short-Term Inflation-Protected Securities ETF (VTIP) and DFA Inflation-Protected Securities (DIPSX) to change each day. I have asked this question a few times but still have a problem understanding. Thanks Paul

I think I may have attempted before, but let's see if I can be extra clear. TIPS are market securities like any other, like stocks, like nominal bonds, like options or futures. Their value is set by the market, and each day market participants change their views. The ETFs own the securities, the values of the securities change, therefore the ETF net asset value changes.

For an already-issued bond, a price change and a yield change are two sides of the same mathematical coin. You know nominal bonds respond to changes in rates. Real bonds, those denominated in inflation-adjusted dollars, respond to changes in a similar number, the real rate, that is, a rate above inflation.

One could say it either way. The values of the bonds change because of changes in real rates, or the real rates change because of the value of the bonds. The math works in both directions.

Some participants in the bond market make constant decisions about how much yield they'll accept, and others are using TIPS for purposes such as collateral, or supporting planned spending. They buy and sell from one another accordingly, which causes the outcome.

Does that help?

PJW

User avatar
Cal Aggie
Posts: 54
Joined: Sat Aug 23, 2014 9:27 am

Re: How TIPS work

Post by Cal Aggie » Wed Oct 15, 2014 7:24 am

Phineas J Whoopee:

Than you for the detailed explanations. I always enjoy your posts and I thought your responses to this question were especially helpful to everyone thinking about TIPS.
What can be added to the happiness of a man who is in health, out of debt, and has a clear conscience? Adam Smith

User avatar
CWRadio
Posts: 300
Joined: Sat Feb 02, 2008 10:04 am
Location: In the Michigan ionosphere

Re: How TIPS work

Post by CWRadio » Wed Oct 15, 2014 8:46 am

Thanks Bubbagump and PJW. I think I now get it. Paul

Post Reply