confused on how tips work

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gips
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confused on how tips work

Post by gips » Sun Sep 30, 2018 10:23 am

Hi,

I've read the wiki here and about five articles on the web, I find them all confusing, here's the source of my confusion:
"If there is inflation, the adjusted principal goes up. If there is deflation, the adjusted principal goes down"

and this quote from investopedia aligns with my definition of deflation:
"Deflation is the general decline in prices for goods and services occurring when the inflation rate falls below 0%. "

Here is the example in the bogleheads wiki:
Like regular bonds, a TIPS bond also pays interest twice a year. The semi-annual interest is calculated by multiplying the adjusted principal by one-half of the interest rate on the bond. For example, if a TIPS bond has a stated interest rate of 2% and the index ratio is 1.035 on the date of the interest payment date, a $1,000 bond will pay interest of

$1,000 * 1.035 * 2% / 2 = $10.35
If the index ratio goes to 1.050 on the next interest payment date six months later, the same bond will pay interest of

$1,000 * 1.050 * 2% / 2 = $10.50
If the index ratio goes to 0.985 on the next interest payment date another six months later, the same bond will pay interest of

$1,000 * 0.985 * 2% / 2 = $9.85


here are my questions:
- is the term "deflation" in the wiki meant to denote a decrease in the inflation rate or is it when the inflation rate falls below 0%?
- If the former, should the principal have been adjusted up after the second payment and down after the third payment? If so, doesn't that render the wiki example incorrect?

tia,

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Phineas J. Whoopee
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Re: confused on how tips work

Post by Phineas J. Whoopee » Sun Sep 30, 2018 11:05 am

gips wrote:
Sun Sep 30, 2018 10:23 am
...
here are my questions:
- is the term "deflation" in the wiki meant to denote a decrease in the inflation rate or is it when the inflation rate falls below 0%?
- If the former, should the principal have been adjusted up after the second payment and down after the third payment? If so, doesn't that render the wiki example incorrect?

tia,
Hi gips.

It means the latter, the inflation rate falling below zero percent which often is called deflation.

A significant decline in the inflation rate in which it stays above zero is sometimes called disinflation. If I were elected language dictator the terms wouldn't be so similar.

PJW

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jeffyscott
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Re: confused on how tips work

Post by jeffyscott » Sun Sep 30, 2018 11:06 am

Deflation is when the inflation rate falls below 0%, to use your wording.

The example does not list the inflation rates, just it's effect on the bond's adjusted principle value. If that ratio is 1.035, my understanding is that means there has been a cumulative net total of 3.5% inflation since the issuance. If it then goes to 1.05 in 6 months, it means the CPI rose by 1.45% in that 6 month period (1.035 x 1.0145 = 1.05). If it goes to 0.985 in the following 6 months it would mean that CPI declined by 6.19% in that 6 month period. (1-0.0691)(1.05) = 0.985
press on, regardless - John C. Bogle

gips
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Re: confused on how tips work

Post by gips » Sun Sep 30, 2018 11:07 am

thanks! still, it seems to me the wiki article is incorrect. shouldn't the balance have been adjusted positively when the index rose?

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Phineas J. Whoopee
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Re: confused on how tips work

Post by Phineas J. Whoopee » Sun Sep 30, 2018 11:15 am

gips wrote:
Sun Sep 30, 2018 11:07 am
thanks! still, it seems to me the wiki article is incorrect. shouldn't the balance have been adjusted positively when the index rose?
TIPS principal values change each business day, with a lag from the most recently announced CPI-U measurement.

PJW

runner3081
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Re: confused on how tips work

Post by runner3081 » Sun Sep 30, 2018 11:37 am

Whew, glad to see this wasn't a post about leaving tips :)

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jeffyscott
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Re: confused on how tips work

Post by jeffyscott » Sun Sep 30, 2018 11:50 am

gips wrote:
Sun Sep 30, 2018 11:07 am
thanks! still, it seems to me the wiki article is incorrect. shouldn't the balance have been adjusted positively when the index rose?
It was, the article says it went 1.035, 1.05, 0.985. I think you are misinterpreting that to mean inflation was 3.5%, then 5%, then -1.5%, but the article does not explicitly state any inflation rates. I calculated the inflation rates that would correspond to the changes in my previous post, 3.5%, 1.45%, and -6.91%.

If instead, inflation were 3.5%, 5%, and -1.5%, then the principle values would be 1.035, 1.08675, and 1.011655575.
press on, regardless - John C. Bogle

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#Cruncher
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Re: confused on how tips work

Post by #Cruncher » Sun Sep 30, 2018 1:59 pm

jeffyscott wrote:
Sun Sep 30, 2018 11:06 am
If that [index] ratio is 1.035, my understanding is that means there has been a cumulative net total of 3.5% inflation since the issuance.
This is correct. The index ratio on each interest payment date equals the interpolated Consumer Price Index (aka Reference CPI) divided by the Reference CPI on the date six months before the first interest payment date (aka Dated Date). To illustrate, here is the interest paid on $1,000 face value of the 2% 5-Year TIPS due April 15, 2012 for which the Dated Date is 4/15/2007. Note the big fall in the CPI from 10/15/2008 to 4/15/2009. This caused the interest payment to fall from $10.82 to $10.43.

Code: Select all

             ---- Consumer Price Index ----
             Jan/Jul   Feb/Aug Interpolated Index Ratio Interest
04/15/2007   202.416   203.499    202.92140     1.00000
10/15/2007   208.299   207.917    208.12648     1.02565    10.26 [*]
04/15/2008   211.080   211.693    211.36607     1.04162    10.42
10/15/2008   219.964   219.086    219.56748     1.08203    10.82
04/15/2009   211.143   212.193    211.63300     1.04293    10.43 "deflation"
10/15/2009   215.351   215.834    215.56913     1.06233    10.62
04/15/2010   216.687   216.741    216.71220     1.06796    10.68 
10/15/2010   218.011   218.312    218.14694     1.07503    10.75
04/15/2011   220.223   221.309    220.72980     1.08776    10.88
10/15/2011   225.922   226.545    226.20335     1.11473    11.15
04/15/2012   226.665   227.663    227.13073     1.11930    11.19
* Example calculations for 10/15/2007. The January/July and February/August CPI are from the BLS Top Picks [] U.S. All items, 1982-84=100 - CUUR0000SA0. The April 15 interpolates between January & February; the October 15 interpolates between July & August.

Code: Select all

208.12648 = 208.299   + (14 / 31) * (207.917 - 208.299)
  1.02565 = 208.12648 / 202.92140
 10.26    =   1.02565 * 1000 * (2% / 2)

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