Two things I don't understand about TIPS

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tc101
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Two things I don't understand about TIPS

Post by tc101 »

Two things I don't understand about TIPS:

1) Inflation is 7% and I-bonds are yielding 7%. Why don't TIPS yield 7% ??

2) People here often say that TIPS protect against "unexpected" inflation. Why is this? Why don't they protect against all inflation?
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mas
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Re: Two things I don't understand about TIPS

Post by mas »

https://www.treasury.gov/resource-cente ... =realyield

1) 10 yr TIPS are yielding -0.79% (real), so with 7% inflation payouts you would get 6.21%. The difference from I-bonds is that there is heavy demand for TIPS in the market and people bid up the price (and lower the yield). I-bonds have no secondary market and purchase limits.

2) They DO protect against expected inflation in the sense that they pay out based on the full CPI. When people make statements like "protecting against unexpected inflation" it is really just semantics, but the market adjusts the current price/yield based on investor expectations and availability of alternate (nominal treasury bonds) investment choices.
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Re: Two things I don't understand about TIPS

Post by vtMaps »

tc101 wrote: Wed Jan 12, 2022 1:16 pm Two things I don't understand about TIPS:

1) Inflation is 7% and I-bonds are yielding 7%. Why don't TIPS yield 7% ??

2) People here often say that TIPS protect against "unexpected" inflation. Why is this? Why don't they protect against all inflation?
The value of the TIPS bond does go up 7%. The coupon does not go up 7%, it is fixed for the life of the bond.

If inflation is as expected, nominal and TIPS bonds will pay similar overall yields. If unexpected inflation comes along, then TIPS will be a better investment.

--vtMaps
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dbr
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Re: Two things I don't understand about TIPS

Post by dbr »

tc101 wrote: Wed Jan 12, 2022 1:16 pm Two things I don't understand about TIPS:

1) Inflation is 7% and I-bonds are yielding 7%. Why don't TIPS yield 7% ??

The distribution yield for the last two quarters annualized for VAIPX has been over 7%. Note that the inflation index is added to the bond principal for a single TIPS but is paid out for a fund. The 2021 return for the year was about 5.5%


2) People here often say that TIPS protect against "unexpected" inflation. Why is this? Why don't they protect against all inflation?

Yes, they are indexed the same for any inflation. People make that odd and misleading statement because all bonds have some inflation expectation priced in, so TIPS are special in that they are indexed for any inflation, expected or not. I think it is a stupid statement, but there is a point behind it. The point is about nominal bonds and not about TIPS.
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Re: Two things I don't understand about TIPS

Post by Thesaints »

tc101 wrote: Wed Jan 12, 2022 1:16 pm Two things I don't understand about TIPS:

1) Inflation is 7% and I-bonds are yielding 7%. Why don't TIPS yield 7% ??
This is not entirely correct.
I-bonds "measure" past inflation every 6 months and, essentially, apply an equivalent correction for the following 6 months paying that correction plus whatever fixed rate was in force when you bought the bond.
TIPS pay a fixed rate established when a particular bond was issued and adjust the principal value monthly (using the month-to-month CPI), but for all practical purposes it is as if they adjusted the principal every six months, looking at the past 6-months inflation. They can reduce the principal running value, if the past 6-months inflation was negative. I-bonds never decrease in value, instead.
2) People here often say that TIPS protect against "unexpected" inflation. Why is this? Why don't they protect against all inflation?
You can always compare a TIPS yield with the same maturity treasury. The difference is what is properly called "implied inflation" and less properly "expected inflation". It means that if future inflation matches the implied one, TIPS or fixed-rate treasuries are equivalent.
If inflation turns out to be lower, then the fixed-rate bond was a better deal, if only one could knew that in advance...
If inflation turns out to be higher, then the fixed-rate bond was a worse deal.
One thing to keep in mind is that if inflation is lower than the implied value, you gain money (in real terms) if you bought a fixed-rate bond. If inflation is higher than the implied value, you don't gain money if you bought a TIPS, but you lose money if you bought a fixed rate bond !
If we say that the implied inflation value is the inflation expected (which is not correct), then you can appreciate how TIPS protect you from "higher than expected inflation", but that is kind of a misnomer.
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Re: Two things I don't understand about TIPS

Post by Angst »

It's almost all simply because I Bonds are non-negotiable (they're almost like an inflation-adjusted passbook savings account, with a few odd features and quirks), while TIPS are auctioned off when issued and then available anytime in a secondary market.

If my I Bonds could magically become negotiable and I could sell them in a secondary market, they would jump in value while their yields would plummet, to levels somewhat comparable to TIPS.

Take a look at the current Treasury real yield curve. TIPS are expensive - their real yields are negative:
https://www.treasury.gov/resource-cente ... &year=2022

With negative real yields, I Bonds are the clear winner over TIPS.
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Re: Two things I don't understand about TIPS

Post by tc101 »

The value of the TIPS bond does go up 7%.
That's what confuses me. In the last year inflation has been 7%, but the vanguard tips funds vipsx and vtapx have not gone up 7% in value.
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Re: Two things I don't understand about TIPS

Post by vtMaps »

tc101 wrote: Wed Jan 12, 2022 1:39 pm
The value of the TIPS bond does go up 7%.
That's what confuses me. In the last year inflation has been 7%, but the vanguard tips funds vipsx and vtapx have not gone up 7% in value.
A TIPS fund is not the same as a TIPS bond. --vtMaps
"Truly, whoever can make you believe absurdities can make you commit atrocities" --Voltaire, as translated by Norman Lewis Torrey
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Re: Two things I don't understand about TIPS

Post by Thesaints »

tc101 wrote: Wed Jan 12, 2022 1:39 pm
The value of the TIPS bond does go up 7%.
That's what confuses me. In the last year inflation has been 7%, but the vanguard tips funds vipsx and vtapx have not gone up 7% in value.
The TIPS principal went up 7%, but one cannot redeem TIPS in advance. You can only sell them on the market and current principal value, combined with their nominal rate, plus the expectation on future inflation, did not to cause bids to go up 7%.
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Re: Two things I don't understand about TIPS

Post by aristotelian »

tc101 wrote: Wed Jan 12, 2022 1:16 pm Two things I don't understand about TIPS:

1) Inflation is 7% and I-bonds are yielding 7%. Why don't TIPS yield 7% ??

2) People here often say that TIPS protect against "unexpected" inflation. Why is this? Why don't they protect against all inflation?
TIPS and I Bonds are different investments. TIPS currently have negative real yield so currently I Bonds are preferable. That could change at some point but not likely any time soon. In effect, the government is subsidizing individuals to save.

I think you are correct to say that TIPS protect against inflation, period. If inflation goes up, TIPS go up even if the market was expecting inflation to go up.

Perhaps what you are confusing is that TIPS are expected to outperform nominal Treasuries if there is unexpected inflation. This is because they have the same credit risk and same expected return. If inflation is less than expected, than the nominal Treasury paying a fixed interest rate will end up doing better. If it is higher than expected, TIPS will do better.
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Re: Two things I don't understand about TIPS

Post by dbr »

tc101 wrote: Wed Jan 12, 2022 1:39 pm
The value of the TIPS bond does go up 7%.
That's what confuses me. In the last year inflation has been 7%, but the vanguard tips funds vipsx and vtapx have not gone up 7% in value.
They have if you account for the dividend and subtract the market risk and recognize that the rate of inflation has not been 7% for a whole year and neither have the interest payments on I bonds, as explained above. Here is the actual composite rate chart:

http://eyebonds.info/ibonds/rates.html
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Re: Two things I don't understand about TIPS

Post by exodusNH »

tc101 wrote: Wed Jan 12, 2022 1:39 pm
The value of the TIPS bond does go up 7%.
That's what confuses me. In the last year inflation has been 7%, but the vanguard tips funds vipsx and vtapx have not gone up 7% in value.
That's not how TIPS funds work. You need to look at the total return. They've paid out the inflation adjustments as dividends. If you don't reinvest them, your fund value (# shares x $price) will indeed drop but when you add back in the dividends, you will see the expected value.
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Re: Two things I don't understand about TIPS

Post by dbr »

The fact that the principal of I bonds and individual TIPS is incremented for inflation but that the inflation increment is paid out from a TIPS fund causes lots of confusion. I think the reason for this is that the TIPS fund has to make the distribution in order to create taxable income for the investor. For single bonds one is taxed on the increment every year, or deferred for I bonds.
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Re: Two things I don't understand about TIPS

Post by GaryA505 »

dbr wrote: Wed Jan 12, 2022 2:08 pm The fact that the principal of I bonds and individual TIPS is incremented for inflation but that the inflation increment is paid out from a TIPS fund causes lots of confusion. I think the reason for this is that the TIPS fund has to make the distribution in order to create taxable income for the investor. For single bonds one is taxed on the increment every year, or deferred for I bonds.
Sounds like TIPS would be bad to have in a taxable account then. Also, what about target date funds that have maybe 15% or so in TIPS.
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Re: Two things I don't understand about TIPS

Post by dbr »

GaryA505 wrote: Wed Jan 12, 2022 2:14 pm
dbr wrote: Wed Jan 12, 2022 2:08 pm The fact that the principal of I bonds and individual TIPS is incremented for inflation but that the inflation increment is paid out from a TIPS fund causes lots of confusion. I think the reason for this is that the TIPS fund has to make the distribution in order to create taxable income for the investor. For single bonds one is taxed on the increment every year, or deferred for I bonds.
Sounds like TIPS would be bad to have in a taxable account then. Also, what about target date funds that have maybe 15% or so in TIPS.
Not any different from any other bonds paying a similar yield and better than most bonds because Treasuries are state tax exempt. I bonds, of course, offer a benefit of tax deferred interest for 30 years, understanding that at the end of the 30 years all the accrued income becomes taxable in one fell swoop. Don't forget single TIPS are also taxed the same in taxable accounts except that they don't actually pay you the income. Of course if you don't reinvest the TIPS fund dividend, then you have made a withdrawal which sabotages the holding keeping pace with inflation. You can withdraw the actual coupon payment, but that is pretty much nothing right now.

Due to the state tax exemption TIPS are more tax efficient in a TD fund than other bonds, but TD funds are just a bad idea in taxable accounts for a whole range of reasons.
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Re: Two things I don't understand about TIPS

Post by exodusNH »

GaryA505 wrote: Wed Jan 12, 2022 2:14 pm
dbr wrote: Wed Jan 12, 2022 2:08 pm The fact that the principal of I bonds and individual TIPS is incremented for inflation but that the inflation increment is paid out from a TIPS fund causes lots of confusion. I think the reason for this is that the TIPS fund has to make the distribution in order to create taxable income for the investor. For single bonds one is taxed on the increment every year, or deferred for I bonds.
Sounds like TIPS would be bad to have in a taxable account then. Also, what about target date funds that have maybe 15% or so in TIPS.
An individual TIPS bond is annoying in taxable because the IRS treats the inflation adjustment as immediately taxable. You have to report the income and pay taxes on it without receiving any money from the bond itself. At small enough holdings, it's not a big deal to come up with the cash. ("Phantom income" / imputed interest.)

TIPS funds pay out the adjustments by selling some of the individual bonds on the open market and paying them out as dividends. At least you have the cash in hand to pay the taxes with.

TDFs would have the same issue, though the holdings are only going to be 15% of 10-40% of the holdings.
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Re: Two things I don't understand about TIPS

Post by jimkitt »

I don't understand TIPS either. However, I get the impression that once interest rates go up(even 25 basis pts), the real value won't be negative and the premium paid will disappear, and newly issued TIPS will sell at face. Not sure if my theory is true , but it seems that way. Therefore, buying TIPS from TD might make sense in March when rates go up.
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Re: Two things I don't understand about TIPS

Post by Thesaints »

dbr wrote: Wed Jan 12, 2022 1:53 pm The rate of inflation has not been 7% for a whole year
Maybe we mean different things, but the rate of inflation has been precisely 7% when measured December 2021-December 2020, i.e. for a whole year.
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Re: Two things I don't understand about TIPS

Post by dbr »

Thesaints wrote: Wed Jan 12, 2022 9:47 pm
dbr wrote: Wed Jan 12, 2022 1:53 pm The rate of inflation has not been 7% for a whole year
Maybe we mean different things, but the rate of inflation has been precisely 7% when measured December 2021-December 2020, i.e. for a whole year.
You're right. The issue is about when the increments are actually made to the bonds, TIPS or I bonds.
Last edited by dbr on Wed Jan 12, 2022 10:47 pm, edited 1 time in total.
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Re: Two things I don't understand about TIPS

Post by grabiner »

tc101 wrote: Wed Jan 12, 2022 1:39 pm
The value of the TIPS bond does go up 7%.
That's what confuses me. In the last year inflation has been 7%, but the vanguard tips funds vipsx and vtapx have not gone up 7% in value.
Vanguard Short-Term Inflation-Protected Securities is up 5.26% for 2021, and Inflation-Protected Securities is up 5.56%. Both funds have negative real yields, so they would slightly underperform inflation if TIPS yields don't change. The return of the fund would be inflation plus the SEC yield (a reduction since the yield is negative). And in 2021, TIPS yields changed very little over the year, so that is what the funds returned.

(The other issue with TIPS returns versus inflation is that the inflation adjustment has a three-month lag; if a TIPS is issued in August, the inflation adjustment for the first month is the May inflation.)
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Re: Two things I don't understand about TIPS

Post by dbr »

grabiner wrote: Wed Jan 12, 2022 10:10 pm
tc101 wrote: Wed Jan 12, 2022 1:39 pm
The value of the TIPS bond does go up 7%.
That's what confuses me. In the last year inflation has been 7%, but the vanguard tips funds vipsx and vtapx have not gone up 7% in value.
Vanguard Short-Term Inflation-Protected Securities is up 5.26% for 2021, and Inflation-Protected Securities is up 5.56%. Both funds have negative real yields, so they would slightly underperform inflation if TIPS yields don't change. The return of the fund would be inflation plus the SEC yield (a reduction since the yield is negative). And in 2021, TIPS yields changed very little over the year, so that is what the funds returned.

(The other issue with TIPS returns versus inflation is that the inflation adjustment has a three-month lag; if a TIPS is issued in August, the inflation adjustment for the first month is the May inflation.)
Good explanation, and just to emphasize a point, in the above "up" means the return for the year. That is the only measure that makes sense to look at. People are often confused by looking at the share price or at the yield alone.
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Re: Two things I don't understand about TIPS

Post by #Cruncher »

grabiner wrote: Wed Jan 12, 2022 10:10 pm... The other issue with TIPS returns versus inflation is that the inflation adjustment has a three-month lag ...
We can see this by looking at the monthly CPIs for 2020 and 2021. [1] The last row in the table below shows that the latest report for December 2021 was a 7.04% increase over December 2020. But this won't be reflected in TIPS principal until March 1st. For the year 2021 TIPS principal increased only 6.22%, corresponding to the year-over-year increase in the October 2021 CPI.

Code: Select all

CPI Month       2020       2021  Increase  TIPS Effec
  January    257.971    261.582     1.40%    4/1/2021
 February    258.678    263.014     1.68%    5/1/2021
    March    258.115    264.877     2.62%    6/1/2021
    April    256.389    267.054     4.16%    7/1/2021
      May    256.394    269.195     4.99%    8/1/2021
     June    257.797    271.696     5.39%    9/1/2021
     July    259.101    273.003     5.37%   10/1/2021
   August    259.918    273.567     5.25%   11/1/2021
September    260.280    274.310     5.39%   12/1/2021
  October    260.388    276.589     6.22%    1/1/2022
 November    260.229    277.948     6.81%    2/1/2022
 December    260.474    278.802     7.04%    3/1/2022
grabiner, previously in same post, wrote:The return of the fund would be inflation plus the SEC yield ...
We can also see this with an individual TIPS where yield-to-maturity corresponds to SEC yield for a fund. I computed the return from 1/4/2021 to 1/3/2022 of the 1/8% coupon TIPS maturing July 2030. I chose these dates because they were about a year apart and the bond yielded about the same both dates, minimizing the effect of yield changes on return.
  • Row 6 in the table below shows that the principal value increased 6.26%, close to the 6.22% increase (of the CPI October 2020 to October 2021 mentioned above) if the dates were January 1st.
  • Row 7 shows that the price declined 1.30%. This is because the yield (both 1/4/2021 and 1/3/2022) was about -1.1%. A bond with a yield less than the coupon will have a price above par, i.e., greater than 100%. As the bond approaches maturity, if its yield remains the same, its price will decline toward the price of 100% that it will have at maturity.
  • Row 8 shows that, combining the 1.30% decline in price with the 6.26% increase in principal reduced the increase in market value to only 4.88%.
  • Row 10 shows that adding in the small coupon interest nudged the increase up to 4.99%.

Code: Select all

Row          Col A       Col B       Col D     Col E
  1     Face value       1,000
  2        Matures   7/15/2030
  3         Coupon      0.125%
  4           Date   1/04/2021   1/03/2022
  5          Yield     -1.124%     -1.115%    Change
  6    Index ratio     1.01553     1.07912     6.26%  [2]
  7      Ask price  112.59375%  111.12500%    -1.30%  [3]
  8   Market value    1,143.42    1,199.17     4.88%  [4]
  9       Interest        0.60        1.92            [5]
 10  With interest    1,144.02    1,201.09     4.99%
  1. CPI figures are from this BLS webpage.
  2. Index ratios are the way the changes in CPI are applied to the principal for each TIPS. These values for this particular TIPS are from its CPI Query Results webpage on TreasuryDirect. (Or these two pages for 2021 and 2022.) For more on this, see the first two paragraphs of the left sidebar on this help page.
  3. Prices are from my spreadsheets where I record the daily closing WSJ TIPS Quotes.
  4. Market value is the product of face value, index ratio, and price. For example:
    1,143.42 = 1000 * 1.01553 * 112.59375%
  5. Here is how the interest is computed where the Accrued percent on 1/4/2021 and 1/3/2022 is based on the days of interest earned.
    1/4/2021: 94.0% = 173 / 184 (interest period 7/15/2020 to 1/15/2021)
    1/3/2022: 93.5% = 172 / 184 (interest period 7/15/2021 to 1/15/2022)

    Code: Select all

         Date  Accrued  Idx ratio  Interest  
    1/04/2021    94.0%    1.01553      0.60  accrued interest paid on purchase
    1/15/2021   100.0%    1.01531      0.63  regular interest payment
    7/15/2021   100.0%    1.04536      0.65  regular interest payment
    1/03/2022    93.5%    1.07912      0.63  accrued interest rec'd on sale
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tc101
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Re: Two things I don't understand about TIPS

Post by tc101 »

Thanks everyone. I have a better understanding after reading this thread.
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Re: Two things I don't understand about TIPS

Post by FactualFran »

dbr wrote: Wed Jan 12, 2022 9:57 pm
Thesaints wrote: Wed Jan 12, 2022 9:47 pm
dbr wrote: Wed Jan 12, 2022 1:53 pm The rate of inflation has not been 7% for a whole year
Maybe we mean different things, but the rate of inflation has been precisely 7% when measured December 2021-December 2020, i.e. for a whole year.
You're right. The issue is about when the increments are actually made to the bonds, TIPS or I bonds.
7% is the difference between the CPI-U for Dec. 2020 and Dec 2021. 4.7% is the difference in the average CPI-U for 2020 and 2021. Someone who bought the basket of goods used to determine the CPI-U
  • only in December of each year would have seen a 7% increase for 2021
  • each month of each year would have seen a 4.7% increase for 2021
The inflation rate for I-bonds uses the difference in the CPI-U between months that are 6 months apart. The inflation rate for TIPS uses the difference in the CPI-U between successive months.
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Re: Two things I don't understand about TIPS

Post by martincmartin »

So here's a confusing thing about TIPS: they're not sold at face value, they're sold at auction.

For example, imagine on Jan 1 of some year, you're buying a 1 year TIPS with a face value of $1000. This means, 1 year from now, it'll pay $1000 plus whatever the actual CPI-U inflation was over that year on that $1000.

How much will this TIPS cost you? Let's say the consensus expectation for inflation is 3%. You're buying something that most people think will pay them $1030 in a year. How much will they pay? The main alternative is regular 1-year Treasuries. Let's say the 1-year Treasury rate is 1%. You'd have to spend $1020 (to the nearest dollar) today on a 1-year Treasury to ensure you'll get $1030 in one year's time.

If the 1-year TIPS cost less than $1020, then people would just buy that instead. If the 1-year TIPS cost more than $1020, nobody would buy them, everybody would by 1-year Treasuries. So, the cost of the TIPS would be $1020, even though the face value is $1000.

So (a) if inflation turns out to be exactly what is expected, it doesn't matter whether you bought the plain Treasury or the TIPS, you'll have $1030 after a year. So it doesn't protect against expected inflation. But if inflation is higher than expected, you'll get more than $1030. So it protects against unexpected inflation.
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