TIPS & Inflation Bonds - Theory

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TIPS & Inflation Bonds - Theory

Post by abuss368 »

I have a question regarding TIPS and Inflation bonds in terms of theory:

* I understand TIPS provide a form of insurance against unexpected inflation.

* The return of TIPS should be at a lower rate over time then nominal bonds due to the protection being paid for.

* All assets have expected inflation built into them.

* Income from TIPS is unexpected because no one knows what actual inflation will be.

* If inflation is calculated to be lower than expected, a nominal bond may return more as the expected inflation factor built into the interest rate will be greater than TIPS.

Here is my question:

1) Over a long time (subjective) would a nominal bond and a TIPS bond not have the same expected return or would the nominal bond be greater?
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Re: TIPS & Inflation Bonds - Theory

Post by ML 59 »

I was afraid to ask this very question - so I'm glad you did.
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Re: TIPS & Inflation Bonds - Theory

Post by Bustoff »

I think it depends on the context. Are you investing to accumulate or investing to preserve ?
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Re: TIPS & Inflation Bonds - Theory

Post by stevewolfe »

abuss368 wrote: Here is my question:

1) Over a long time (subjective) would a nominal bond and a TIPS bond not have the same expected return or would the nominal bond be greater?
I'd say that an intermediate term, high quality nominal bond fund like Vanguard Total Bond (for example) would have a very slightly higher expected return due to the inflation premium over time if inflation approximates expectations (reinvesting dividends in both cases and holding in tax deferred).

If there is unexpected inflation then likely not - but we already knew that right? If folks want inflation protection but don't want the fluctuation of the longer duration TIPS funds there is a short term fund alternative - but you may not like the rates. If you want to roll your own and buy individual TIPS bonds you can pick your real return - and hold to maturity.

Or you can forget all of that and start building a position in I-Bonds. Often this suggestion is poo-poo'ed as unrealistic / insignificant due to limits. A married couple can add $20k this year (without a trust) and $20k next year. On a $500k portfolio that gives you an 8% allocation in inflation protected bonds. If you start accumulating them they can, and do add up, I promise. :beer
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Re: TIPS & Inflation Bonds - Theory

Post by thx1138 »

My understanding - or perhaps "assumption" is the better word - is that over the "long term" you would get more return from nominals since you should be getting a inflation risk premium.

As a side note, this statement:
Income from TIPS is unexpected because no one knows what actual inflation will be.
is a behavioral economist's dream example of a classic investor error. Nominal returns are irrelevant, they have no meaning when it comes to utility to the investor. Only real returns matter. So what you should have said was "Income from nominals is unexpected because no one knows what actual inflation will be". That is the correct statement and the only way to properly evaluate investments and returns. But of course we all tend to look at it the way you originally stated which is actually a perverse cognitive error.
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Re: TIPS & Inflation Bonds - Theory

Post by tetractys »

Sorry, but the future is unknown. That said, if unexpected inflation manifests to a great enough degree over the long term, then TIPS could win. Otherwise probably nominals.

Also note that Vanguard only uses TIPS for their later dated Target Retirement funds. You might try and deduce some wisdom from that. But I couldn't tell you how much of Vanguard's reasons could stem from economies of market, as in how many investors they plan to accommodate down the line, with TIPS now being a smaller part of that market.

Larry has been saying something like, "the bulk of an investor's fixed income should be in TIPS." But you know, I have no idea what he means by that; I wish he'd explain in detail--or maybe I missed it. -- Tet
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Re: TIPS & Inflation Bonds - Theory

Post by abuss368 »

ML 59 wrote:I was afraid to ask this very question - so I'm glad you did.
Why were you afraid? Is it because often it is the TIPS way or the highway?
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Re: TIPS & Inflation Bonds - Theory

Post by Call_Me_Op »

abuss368 wrote:I have a question regarding TIPS and Inflation bonds in terms of theory:

* I understand TIPS provide a form of insurance against unexpected inflation.

* The return of TIPS should be at a lower rate over time then nominal bonds due to the protection being paid for.
Not really. The "breakeven inflation rate" is considered to be the nominal rate minus the TIPS fixed rate. This breakeven rate is usually considered to be the expected inflation rate.
abuss368 wrote:* All assets have expected inflation built into them.

* Income from TIPS is unexpected because no one knows what actual inflation will be.
I would not say that income from TIPS is unexpected. I would say that it is not known beforehand.
abuss368 wrote:* If inflation is calculated to be lower than expected, a nominal bond may return more as the expected inflation factor built into the interest rate will be greater than TIPS.
More or less correct.
abuss368 wrote:Here is my question:

1) Over a long time (subjective) would a nominal bond and a TIPS bond not have the same expected return or would the nominal bond be greater?
They have about the same expected return. That is, if the "breakeven inflation rate" is the expected inflation rate, they have exactly the same expected return.
Last edited by Call_Me_Op on Wed Nov 27, 2013 7:51 pm, edited 1 time in total.
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Re: TIPS & Inflation Bonds - Theory

Post by Ketawa »

The breakeven inflation rate is slightly higher than the expected inflation rate. Nominals are expected to return slightly more. Otherwise, long-term investors would always use TIPS.
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Re: TIPS & Inflation Bonds - Theory

Post by Call_Me_Op »

Ketawa wrote:The breakeven inflation rate is slightly higher than the expected inflation rate. Nominals are expected to return slightly more. Otherwise, long-term investors would always use TIPS.
We don't really know that to be fact. All we know is the breakeven rate - and that is usually considered to be the expected rate. There are various factors that may cause these to be different, but they are generally not knowable, and so the breakeven rate is the best estimate we have for expected inflation.

I don't think we can say that investors would always choose TIPS if the breakeven rate equals the expected rate. There is just as much chance that inflation will be lower than expected as there is that it will be higher than expected. And TIPS tend to be less liquid than nominals.
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Re: TIPS & Inflation Bonds - Theory

Post by abuss368 »

Excellent. Thank you for helping me better understand the theory thus far.
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Re: TIPS & Inflation Bonds - Theory

Post by steve_14 »

abuss368 wrote:* I understand TIPS provide a form of insurance against unexpected inflation.

* The return of TIPS should be at a lower rate over time then nominal bonds due to the protection being paid for.
That's just conjecture IMO - could be that investors value the deflation/recession protection of conventional bonds more.
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Re: TIPS & Inflation Bonds - Theory

Post by abuss368 »

steve_14 wrote:
abuss368 wrote:* I understand TIPS provide a form of insurance against unexpected inflation.

* The return of TIPS should be at a lower rate over time then nominal bonds due to the protection being paid for.
That's just conjecture IMO - could be that investors value the deflation/recession protection of conventional bonds more.
I know I do. The income is predictable and paid in monthly dividends!
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Re: TIPS & Inflation Bonds - Theory

Post by G-Money »

abuss368 wrote:
steve_14 wrote:
abuss368 wrote:* I understand TIPS provide a form of insurance against unexpected inflation.

* The return of TIPS should be at a lower rate over time then nominal bonds due to the protection being paid for.
That's just conjecture IMO - could be that investors value the deflation/recession protection of conventional bonds more.
I know I do. The income is predictable and paid in monthly dividends!
To clarify, the nominal income of nominal bonds is predictable. The real value of that income is unknown.
Don't assume I know what I'm talking about.
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Re: TIPS & Inflation Bonds - Theory

Post by abuss368 »

Ketawa wrote:The breakeven inflation rate is slightly higher than the expected inflation rate. Nominals are expected to return slightly more. Otherwise, long-term investors would always use TIPS.
Is this correct? Could someone explain in additional detail.
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Re: TIPS & Inflation Bonds - Theory

Post by Ketawa »

If the breakeven inflation rate was the same as the expected inflation rate, why would investors use nominals? You could get the same expected real return without the risk of unexpected inflation. In the end, it's probably not a big difference.
Call_Me_Op wrote:We don't really know that to be fact. All we know is the breakeven rate - and that is usually considered to be the expected rate. There are various factors that may cause these to be different, but they are generally not knowable, and so the breakeven rate is the best estimate we have for expected inflation.
When he did his periodic TIPS updates, Larry Swedroe used to use a Fed forecast as the estimate for inflation. I think that would be a better estimate than naively using the breakeven rate as the expected rate. Investors should rationally demand higher yields for nominals of the same duration/maturity since they will bear the risk of unexpected inflation.
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Re: TIPS & Inflation Bonds - Theory

Post by G-Money »

Ketawa wrote:If the breakeven inflation rate was the same as the expected inflation rate, why would investors use nominals? You could get the same expected real return without the risk of unexpected inflation. In the end, it's probably not a big difference.
Call_Me_Op wrote:We don't really know that to be fact. All we know is the breakeven rate - and that is usually considered to be the expected rate. There are various factors that may cause these to be different, but they are generally not knowable, and so the breakeven rate is the best estimate we have for expected inflation.
When he did his periodic TIPS updates, Larry Swedroe used to use a Fed forecast as the estimate for inflation. I think that would be a better estimate than naively using the breakeven rate as the expected rate. Investors should rationally demand higher yields for nominals of the same duration/maturity since they will bear the risk of unexpected inflation.
As noted in some of Larry's updates, sometimes the premium was negative. In other words, investors were being compensated to eliminate inflation risk. An alternative explanation, of course, is that the Fed forecast of inflation did not match the market's expectation of future inflation.
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Re: TIPS & Inflation Bonds - Theory

Post by Doc »

G-Money wrote:As noted in some of Larry's updates, sometimes the premium was negative. In other words, investors were being compensated to eliminate inflation risk. An alternative explanation, of course, is that the Fed forecast of inflation did not match the market's expectation of future inflation.
TIPS also have a smaller market and are not as liquid as nominal Treasuries which can affect their price. This can make it look like there is a negative inflation premium. The banking crisis in '08 may be a good example but it is conflated with deflation concerns.
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Re: TIPS & Inflation Bonds - Theory

Post by momar »

People use TIPS as a speculative asset. Don't believe it? See how nuts people get about 'imminent' inflation in an era of almost non-existent inflation.

I also disagree that only real returns and not nominal returns are meaningful. Many of my fixed short term and medium term expenses and even some long term expenses are in nominal dollars. I would also ask exactly how many businesses are writing contracts in real dollars.
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Re: TIPS & Inflation Bonds - Theory

Post by Bustoff »

This question is a little off topic. At the boglehead conference in October, Gus Sauter remarked that he felt an allocation of 50% TIPS was too high right now.
Does anyone know if he meant 50% overall or 50% of fixed income?
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Re: TIPS & Inflation Bonds - Theory

Post by Phineas J. Whoopee »

The good thing about the breakeven inflation rate is we all can calculate it, and we can all agree on it.

One argument says the breakeven rate is higher than the expected inflation rate, because most certainly TIPS and their ilk carry less inflation risk (would everybody please note the distinction between ACRONYMS and non-acronyms like Fed and Roth, and for that matter, the word ilk), therefore there must be a risk premium collected by nominal-bond investors for bearing inflation risk themselves.

Another, non-contradictory argument says TIPS are less liquid than nominal Treasuries, as perhaps or perhaps not demonstrated by the movement in TIPS yields (or prices if you insist but it works out the same) in the weeks following Lehman's failure, and therefore pay an illiquidity premium. TIPS haven't existed for long enough for us to be sure how much was systemic risk and how much was idiosyncratic to that portion of the recent financial crisis.

Both premia must exist. They must be in opposite directions. There are estimates, but not calculations.

My own choice is to calculate what I can (the breakeven rate), and not to treat it as overly precise. What difference would it make to my decisions, if it were a little more or a little less than expected inflation? None. If I were managing highly leveraged multi-billion-dollar bond portfolios and my salary, bonus, continued employment, and reputation on the Street were on the line, it would make a difference to my decisions. But I'm not.

At least my access to healthcare would be relatively constant starting in 34 days.

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Re: TIPS & Inflation Bonds - Theory

Post by Ketawa »

Phineas J. Whoopee wrote:The good t breakeven inflation rate is we all can calculate it, and we can all agree on it.

...

PJW
+1 great post. I guess I believe that Bogleheads generally don't face much risk from illiquidity.
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Re: TIPS & Inflation Bonds - Theory

Post by abuss368 »

Bustoff wrote:This question is a little off topic. At the boglehead conference in October, Gus Sauter remarked that he felt an allocation of 50% TIPS was too high right now.
Does anyone know if he meant 50% overall or 50% of fixed income?
I understand that he also referred to TIPS as "scary"!
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Re: TIPS & Inflation Bonds - Theory

Post by Bustoff »

abuss368 wrote:
Bustoff wrote:This question is a little off topic. At the boglehead conference in October, Gus Sauter remarked that he felt an allocation of 50% TIPS was too high right now.
Does anyone know if he meant 50% overall or 50% of fixed income?
I understand that he also referred to TIPS as "scary"!
And Dr. Bernstein said he wouldn't be in any rush to buy them now.
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Re: TIPS & Inflation Bonds - Theory

Post by stlutz »

Most investors invest in a portfolio of assets, not just a single asset. As such, the question is not just what TIPS will return vs. nominals, but how those assets will interact with your portfolio as a whole.

In 2008, nominals really helped someone who had a lot of equities in their portfolio. TIPS did not. Overall, TIPS have higher equity correlation than nominals do.

As such, I would personally demand that TIPS return more (on an inflation-adjusted basis), not less, than nominal bonds do before I would buy them. For many other investors, the same is true.

In short, it's far from obvious that one should expect nominals to offer higher returns than TIPS after inflation. Their pricing will always vary depending upon what investors are actually looking for fixed income securities to do for them at any given time.
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Re: TIPS & Inflation Bonds - Theory

Post by Doc »

Ketawa wrote:I guess I believe that Bogleheads generally don't face much risk from illiquidity.
"Generally" might be correct with regard to TIPS but those individual TIPS that I was counting on to gain and not lose value to give me dry powder to rebalance in the '08 crisis turned out to be very wet powder.

The trouble with illiquidity is that it shows up at all the wrong times. The whole '08 banking debacle was precipitated by the lack of liquidity in the MBS market. And that crisis probably affected all of us.
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Re: TIPS & Inflation Bonds - Theory

Post by Clive »

Over a long time (subjective) would a nominal bond and a TIPS bond not have the same expected return or would the nominal bond be greater?
1st June 1988 to 22nd November 2013 inclusive, 6426 (business) days worth of data for UK Government Index Linked Gilts (like TIPS) and Government Conventional Gilts.

All possible sequential 200 days total gains calculated and summarised :

Inflation Conventional
Bond Bond
1.06391 1.06444 Average
0.05182 0.05473 Std. Dev.
0.92176 0.90631 Min
1.23065 1.24585 Max

Sorted and line plotted (left to right tails) indicates near identical lines visually.

Respective Pythagorean annualised approximations

6.264724895% 6.299199767%

Near-as - identical.

Data was Barclays total return (nominal) Indicies, which include a span across all maturities (short to long term).
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Re: TIPS & Inflation Bonds - Theory

Post by Angst »

stlutz wrote:Most investors invest in a portfolio of assets, not just a single asset. As such, the question is not just what TIPS will return vs. nominals, but how those assets will interact with your portfolio as a whole.

In 2008, nominals really helped someone who had a lot of equities in their portfolio. TIPS did not. Overall, TIPS have higher equity correlation than nominals do.

As such, I would personally demand that TIPS return more (on an inflation-adjusted basis), not less, than nominal bonds do before I would buy them. For many other investors, the same is true.

In short, it's far from obvious that one should expect nominals to offer higher returns than TIPS after inflation. Their pricing will always vary depending upon what investors are actually looking for fixed income securities to do for them at any given time.
Doc wrote:
Ketawa wrote:I guess I believe that Bogleheads generally don't face much risk from illiquidity.
"Generally" might be correct with regard to TIPS but those individual TIPS that I was counting on to gain and not lose value to give me dry powder to rebalance in the '08 crisis turned out to be very wet powder.

The trouble with illiquidity is that it shows up at all the wrong times. The whole '08 banking debacle was precipitated by the lack of liquidity in the MBS market. And that crisis probably affected all of us.
Gee, I'm not sure what to make of this kind of thinking. I have enough trouble committing to relying on the various historical correlations data we have going all the way back to the Great Depression, not to worry a lot about TIPS. TIPS have been around for what, barely 15 years? I'm not sure either the equity correlation or the liquidity thing are going to last long term as the amount of outstanding TIPS continues to grow. Then again, who knows? Maybe in the short term, it's really what matters the most. Still, I'm not inclined to give it a lot of weight
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Re: TIPS & Inflation Bonds - Theory

Post by larryswedroe »

Few thoughts
First, in normal times, and with the dramatic increase in TIPS now outstanding, the liquidity premium is probably pretty close to zero. Might go up in a financial crisis/flight to liquidity, but I would say it's for all intents and purposes close to zero.

Second, the nominal rate is made up of real rate, plus expected inflation, plus risk premium for unexpected inflation. So if you assume zero for liquidity, or close to it, TIPS have lower expected returns.

Third, the academic literature is very clear, one sided, that TIPS should dominate the FI portion of the bonds unless the risk premium is high, say 50bp or more for most people--reason simple, most are risk averse. For those with more exposure to unexpected inflation, you should require an even larger risk premium to buy nominals. If less exposure you can accept lower.

Fourth, with CD rates typically above Treasury rates you should look at the risk premium relative to CDs as the riskless alternative, not Treasuries.

Hope that helps.

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Re: TIPS & Inflation Bonds - Theory

Post by stockpickerted »

The Apr2028(3.625%) TIP is selling for $132.28 while the Inflation Factor is 1.44408. Doesn't that reflect a $12 discount at this time? Conversly, the Jan2029(2.5%) is selling for $117.29 while the Inflation Factor is 1.08787. Doesn't that reflect a $8.50 premium at this time and make the Apr2028 a better buy of the two? I realize that my terminology might not be perfect TIPish but you get the gyst.
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Re: TIPS & Inflation Bonds - Theory

Post by Bustoff »

abuss368 wrote:I have a question regarding TIPS and Inflation bonds in terms of theory:

* I understand TIPS provide a form of insurance against unexpected inflation.

* The return of TIPS should be at a lower rate over time then nominal bonds due to the protection being paid for.

* All assets have expected inflation built into them.

* Income from TIPS is unexpected because no one knows what actual inflation will be.

* If inflation is calculated to be lower than expected, a nominal bond may return more as the expected inflation factor built into the interest rate will be greater than TIPS.

Here is my question:

1) Over a long time (subjective) would a nominal bond and a TIPS bond not have the same expected return or would the nominal bond be greater?
abuss,
Saw your thread while searching for information re TIPS. I had recently seen this chart and thought I would pass it along. Not sure however if the break-even inflation rate on this chart applies to your question, so please disregard if that's the case.
http://www.zvibodie.com/marketindicatorsview
bustoff

PS - thank you the reminder #Cruncher
Last edited by Bustoff on Fri Dec 06, 2013 2:39 pm, edited 2 times in total.
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Re: TIPS & Inflation Bonds - Theory

Post by #Cruncher »

stockpickerted wrote:The Apr2028(3.625%) TIP is selling for $132.28 while the Inflation Factor is 1.44408. Doesn't that reflect a $12 discount at this time?
No, You're mixing up two separate things, stockpickerted. The price of $132.875 (that's 132 + 28/32) is what one has to pay for each $100 of inflation-adjusted principal. As of 12/5/2013 the inflation factor is 1.44721 (1.44408 is the factor as of 12/31/2013). So the total one would have to pay for each $100 of face value is $132.875 X 1.44721 or $192.30. The purchase price premium is simply the extra 32.875% that the price exceeds 100%.

Sources: WSJ TIPS Quotes 12/04/2013 and 4/15/2013 TIPS Index Ratios for 2013
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Re: TIPS & Inflation Bonds - Theory

Post by nisiprius »

abuss368 wrote:...
* Income from TIPS is unexpected because no one knows what actual inflation will be....
I believe this is exactly the wrong way to think about it. I believe one should think in real dollars. It is income from nominal bonds that is "unexpected because no one knows what actual inflation will be." What's attractive about TIPS is that the income (and principal at maturity) IS expected--if you measure in year-2013 dollars.
Over a long time (subjective) would a nominal bond and a TIPS bond not have the same expected return or would the nominal bond be greater?
I don't know the official answer. It would seem to me that, as you say, a nominal bond ought to include a risk premium for the inflation risk you are taking, and/or with the TIPS you would expect to have a pay a premium for the extra safety. The odd thing is that it seems to be so small that it is lost in the noise--that is to say, in the period they have existed, TIPS have actually paid more than nominals.

Another way to say this is that there's no point in trying to do rational homo-economicus-type analysis, because the vagaries of the market are much larger than anything you can analyze or predict. To mention two big ones: 1) the higher historic returns from TIPS are probably a one-time anomaly due to the Treasury having to pay high interest in the first few years in order to get people to buy these new, unfamiliar things. 2) TIPS seem to be more thinly traded and subject to liquidity issues--at any rate, they seem to fluctuate in market value more than nominal bonds, and the two conspicuous examples were a weird 10% rise in 2007 followed by a weird 10% fall in 2008.

I don't think there's any point at all in trying to figure out whether TIPS will do better or worse than nominals. Leave that to the traders, and I think all the stuff about TIPS being "hard to understand" or "not having been around to have a track record" has to do with that. Assume an efficient market, and buy TIPS if what you want is a fixed real return, and nominals if what you want is a fixed dollar-number return.
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Re: TIPS & Inflation Bonds - Theory

Post by midareff »

Abuss... I see this as coming down to several issues. Since the inflation is UNEXPECTED the instrument that compensates for that might be in a better position HOWEVER; what happened as a result of that unexpected inflation? Did the Fed raise rates to control the inflation and thereby drive the TIPS fund down in value commensurate with its duration?

It's a good question but the answer will be elusive ...
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Re: TIPS & Inflation Bonds - Theory

Post by stockpickerted »

Cruncher, So are you saying that the price per $100 is $192.30 as of today? I probably misunderstood your answer because I think it is 132.87 if I went to buy it now, what am I missing. If the TIP matured today wouldn't it be worth $144.72?
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Re: TIPS & Inflation Bonds - Theory

Post by #Cruncher »

Ted, here's another way to look at it: The price per $100 of inflation-adjusted principal is $132.875. As of 12/5/2013, $100 of inflation-adjusted principal corresponds to $69.10 of face value (100 / 1.44721) . So one will pay $1.923 per $1 of face value (132.87 / 69.10).

Yes, if the TIPS matured today, $100 face value would be redeemed for $144.72. But they don't mature today. Buying today one will get 14.5 years of above-market interest in addition to $144.72 (plus future inflation-adjustments) at maturity in April 2028.
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