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What are TIPS - Treasury Inflation Protected Securities - YouTube
Channel: Learn to Invest - Investors Grow
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Treasury inflation-protected securities
are often called tips for short tips are
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a type of government bond that accounts
for the fact that prices of goods and
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services change over time they call this
inflation let's look a bit closer first
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let's imagine that you bought $1,000 of
a typical 30 year Treasury bond and this
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bond pays interest at a rate of 3% per
year this is called the nominal interest
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rate nominal simply means the interest
rate you receive before inflation if you
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adjust the interest rate by inflation
well they call this the real rate of
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return so you can calculate the real
rate of return by simply taking our
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three percent and subtracting inflation
as measured by the consumer price index
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often called CPI so if the CPI shows
that inflation went up by let's say 2%
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while our real rate of return for these
government bonds is just 1% but here's
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where it gets interesting
to illustrate inflation movements here's
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an actual chart of the CPI since the
1950s and yes inflation went a bit nuts
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in the 70s and early 80s but you can see
that inflation hit almost 4% as recently
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as 2011 and 5% in 2008 so what are the
alternatives this is where tips or
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Treasury inflation-protected securities
step in you can buy tips for 5 10 or
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even 30 year terms but let's stick with
our 30-year example so you invest the
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same 1,000 dollars in tips and let's
imagine that this 30-year tips will pay
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the same 3% as the regular bond it
wouldn't but we'll come back to that in
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a minute so you pay the $1,000 this has
a few names it can be called it can be
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called principle or face value or even
par value so the face value is your
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month it's going to be paid back to you
when the bonds life ends in this case 30
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years from now the 3 percent well this
is how much needs to be paid to you the
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investor each year but government bonds
actually pay interest twice a year so
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that 3% on the $1,000 is $30 per year
which is $15 every six months simple
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enough
now this math is true for both regular
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bonds and TIPS but what about inflation
so let's imagine that after the first
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year inflation was 2% well what makes
tips unique
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is that the face value in our case
the $1,000 is adjusted by the
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inflation rate so now our face value is
1020 dollars went by tips the interest
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rate you received when the bond was
issued is locked but the interest
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payments paid is a reflection of both
the fixed interest rate and the face
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value of the bond that is adjusted with
inflation so now the 3% interest payment
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the government owes you is 30 dollars
and 60 cents
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divide that by 2 to account for the two
payments in a year and you get 15
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dollars and 30 cents for this
semi-annual payment so what's the catch
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well first off in our hypothetical
scenario we had both a traditional
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30-year bond pay 3% and the Treasury
inflation-protected securities a percent
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the only way this would really happen is
if inflation is expected to be 0% and
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that's extraordinarily unlikely sticking
with more realistic numbers it's more
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likely that inflation is expected to be
let's say 2% this would mean that the
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traditional bond would pay an interest
rate of 3% while tips would pay an
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interest rate of 1% this accounts the
expected inflation rate so with this in
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mind our tips worth it well it depends
what's the average inflation rate for
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the life of the bond if the inflation
rate over the 30 years averaged more
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than 2% which is the initial spread
between the traditional and tips
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well the tips would have a greater total
return if the average rate was less than
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2% but the total return would be less
than traditional bonds if inflation was
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exactly 2% well the total return would
be the same they call this 2% the
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break-even rate now what about deflation
deflation is when the inflation rate is
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negative well if deflation occurs the
bond value decreases so if the face
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value was 1,000 dollars and then the
inflation rate was negative 1 percent
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while the $1000 would fall by 1% or 10
dollars so now our face value is just
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990 dollars and let's imagine that
deflation stuck around for a little
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while and although you invested $1,000
at the start your tips term is coming to
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an end
and currently they have a face value of
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just 950 dollars what happens when you
go to get repaid your bonds face value
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well the government will repay you the
full one thousand dollars the rule is
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that you will be repaid the current face
value or par value par value is the
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initial face value of the bond in our
case one thousand dollars so if your
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face value had climbed all the way to
let's say twelve hundred dollars and the
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deflation occurred knocking your face
value down to let's say 1150 well you
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will be repaid the 1150 since that is
higher than the original par value and
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for our final point let's take a quick
look at taxes with either tips or
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traditional bonds your interest payments
every six months are subject to federal
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income tax but with tips the adjustment
to the face value due to inflation is
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also subject to tax which means that if
inflation was the original 2% we
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mentioned and our $1000 face value was
adjusted higher by that 2% giving us a
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$20.00 gain well will be taxed on that
$20.00 gain even though we will not be
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given the $20.00 until the end of the
bonds life they call this phantom income
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if deflation occurs while our phantom
losses can now be used to offset our
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taxes if you have any questions about
the world of investing any suggestions
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