Understanding TIPS

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yogi414
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Understanding TIPS

Post by yogi414 » Tue Dec 04, 2018 11:08 am

Just bought some TIPS @98.82 offer price, coupon of 0.125% and a Yield to worst of 3.469%.

I was surprised that I had to pay $10640 for a quantity of 10000. The value in the account is currently listed as $10640.

When it matures, will I receive the $10640 + the interest or just $10000 + interest?

Thanks

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Phineas J. Whoopee
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Re: Understanding TIPS

Post by Phineas J. Whoopee » Tue Dec 04, 2018 3:55 pm

The key to understanding TIPS is the face value gets adjusted in line with CPI-U.

You will receive the inflation-adjusted face value, or $10,000 whichever is more. You will also receive inflation-adjusted coupons.

The government does not set marketable securities prices. The market does that.

PJW

alex_686
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Re: Understanding TIPS

Post by alex_686 » Tue Dec 04, 2018 4:11 pm

Welcome to the forum.

TIPS earn "inflation income". IIRC, This is added daily to the par value of your bonds. So depending on the vintage your bond's par could easily be 10640. Figure out the CUSIP and you should be able to look up the actual par value on the Treasury's website.

Grt2bOutdoors
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Re: Understanding TIPS

Post by Grt2bOutdoors » Tue Dec 04, 2018 4:19 pm

yogi414 wrote:
Tue Dec 04, 2018 11:08 am
Just bought some TIPS @98.82 offer price, coupon of 0.125% and a Yield to worst of 3.469%.

I was surprised that I had to pay $10640 for a quantity of 10000. The value in the account is currently listed as $10640.

When it matures, will I receive the $10640 + the interest or just $10000 + interest?

Thanks
Depends if we encounter deflation. Deflation will erode the value of the securities. Let’s say inflation adjusted value is $10,640 today. Deflation comes in and the inflation factor is decreased to account for deflation percentage, the value you receive at maturity could be more (inflation adjusted) or less (deflation adjusted) from your purchase price. If you had bought at auction, face value received at maturity will equal purchase price, even if there is deflation. There is floor protection but you have to purchase an original issue TIP, not a secondary issue traded on open markets as you did in this example. Treasury direct offers a good in depth series of articles on how TIP securities work.
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FactualFran
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Re: Understanding TIPS

Post by FactualFran » Tue Dec 04, 2018 4:35 pm

As others have posted, at maturity you will receive the inflation-adjusted principal and the interest payment on it.

The 98.82 offer price was the price for $100 of face value not adjusted for inflation since the TIPS was issued. The bottom line price of $10,640 for $10,000 of face value included 1) the inflation adjustment since the TIPS was issued and 2) the accrued interest since the most recent interest payment that was made, which was likely a relatively small amount.

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Peculiar_Investor
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Re: Understanding TIPS

Post by Peculiar_Investor » Tue Dec 04, 2018 4:57 pm

As a newcomer to the forum I don't know whether the OP is aware there is also a Bogleheads wiki. It has an article, Treasury Inflation Protected Security (TIPS), that might be helpful, particularly the How it works section.
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#Cruncher
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Re: Understanding TIPS

Post by #Cruncher » Thu Dec 06, 2018 8:04 am

yogi414 wrote:
Tue Dec 04, 2018 11:08 am
When [the TIPS] matures, will I receive the $10640 + the interest or just $10000 + interest?
You will receive $10,000 plus 1/2 the coupon both multiplied by the inflation index ratio. From your description of the price and yield, you're referring to the 0.125% 5-Year TIPS Maturing 4/15/2019. (In future posts, yogi414, please include the coupon and maturity date when referring to a particular bond.)

We won't know the index ratio on 4/15/2019 until the February Consumer Price Index (CPI) is released on March 12, 2019. But, because your 3.469% yield to maturity (YTM) is higher than the YTM on nominal Treasury securities maturing at about the same time, we can tell that the market expects the index ratio to be lower.

From the Daily Treasury Yield Curve, it appears such nominal Treasuries are yielding about 2.5%. Row 12 of the following table shows that for your TIPS to also have a nominal yield of 2.5%, its index ratio needs to fall 0.34% from the 1.07757 it is on 12/5/2018 to about 1.07394 on 4/15/2019. So, if the nominal yield does in fact come in at 2.5%, you will receive $10,746.

Code: Select all

  1  Prior interest paid    10/15/2018
  2  Settlement             12/05/2018
  3  Maturity               04/15/2019
  4  Days to settlement             51
  5  Days to maturity              131
  6  Days in period                182
  7  Coupon                     0.125%
  8  Price                    98.8200%
  9  Accrued interest          0.0175% = (0.125% / 2) * (51 / 182)
                                  Real  Index Ratio     Nominal
 11  Total purchase           98.8375%      1.07757   106.5043%
 12  Redemption              100.0625%      1.07394   107.4609% = 106.5043% * 1.0125 ^ (131/182)
 13  Yield to maturity           3.45%                    2.50%

Grt2bOutdoors wrote:
Tue Dec 04, 2018 4:19 pm
If you had bought at auction, face value received at maturity will equal purchase price, even if there is deflation.
This isn't quite right. According to the FAQ, What happens to TIPS if deflation occurs?,
… at maturity, if the adjusted principal is less than the security's original principal, you are paid the original principal.
The Treasury only guarantees to pay the original principal, not the original price. For example, for each $101.87 paid at the initial auction of the original poster's TIPS, the Treasury promises to pay a minimum of only $100. [*]

Grt2bOutdoors, continuing, wrote:There is floor protection but you have to purchase an original issue TIP, not a secondary issue traded on open markets as you did in this example.
This isn't quite right, either. The floor protection applies just as much to purchases made in the secondary market. For example, in the extremely unlikely event the index ratio of the original poster's TIPS is less than 1.0 at maturity, he wll receive the original $10,000 principal, (as Phineas J. Whoopee points out above) even though he didn't buy at auction.

* There is ambiguity in the meaning of "original" in the Treasury's term "original principal". If "original" refers to the "Dated Date" of 4/15/2014, when the index ratio is initialized at 1.0, then the guarantee would indeed be $100. But if it refers to the "Original Issue Date" of 4/30/2014 when the index ratio was 1.00185, the guarantee would be $100.185.

yogi414
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Re: Understanding TIPS

Post by yogi414 » Sat Dec 08, 2018 10:00 am

I appreciate all the valuable feedback. I guess the lesson learned for me is that in TIPS contrary to other bonds not only are you not guaranteed the yield to worst that is "advertised" in my case 3.469% but the principal investment could also be lower. I'll ride it out to maturity and see what happens. I hope #cruncher is right... Thanks again for all the input!

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