Treasury Inflation-Protected Securities (TIPS)

Investors who hold bonds generally earn a fixed nominal rate of return. However, the nominal return that they earn is in turn composed of two parts.

1. One part compensates the investors for the inflation which has increased in the external world while their money has been locked in the security.

2. The second part is the real growth that the investor’s portfolio experiences. Hence, even though the nominal rate of return is fixed, the real rate of return for investors varies over time.

From the above-mentioned equation, it is easy to see that if the return remains at a fixed rate while the inflation increases, then the real return earned by investors decreases. Hence, inflation can be considered to be amongst the biggest threats faced by investors who invest in fixed-income securities.

There are many investors who are wary of a drop in their real investment rates.

In this article, we will have a closer look at how treasury inflation-protected securities work as well as their disadvantages.

What are Treasury Inflation-Protected Securities?

Treasury inflation-protected securities are special types of bonds which are issued by the United States government. These bonds have been created in order to protect the investor against the impact of inflation. This is done by adjusting the face value of the bond.

Treasury inflation-protected securities can be easily understood with the help of an example.

For instance, let’s assume that when the bond is issued, its face value is $100 and it pays a 6 percent coupon i.e. $3 every six months. The bond has an inbuilt mechanism for measuring inflation. In most parts of the world, inflation indexes published by the government are used for this purpose.

For instance, the United States uses the consumer price index for tracking inflation. Hence, if the CPI has gone up by 10% during the year, the face value of the bond will also automatically increase to $110.

As a result, the six months interest will also adjust to $3.3. It is important to note that the yield percentage remains the same. It is the coupon that adjusts from time to time based on inflation data.

Treasury inflation protection securities are issued by the United States treasury in a wide variety of maturities. As a result, they find their way into the portfolio of investors with different time preferences.

Also, it is important to note that investors who buy inflation-protected bonds are in essence locking up a real yield. Hence, these types of bonds can be considered to be a type of insurance against inflation.

Issues With Purchasing Treasury Inflation-Protected Securities

The issues most commonly associated with purchasing treasury inflation-protected securities are as follows:

• Firstly, inflation-protected securities are a very popular financial product. This means that there is always a huge demand for buying these products. At the same time, the supply for these securities is limited. As a result, the real yields on some of these securities are abysmally low.

  There have been cases where some of these securities have actually carried a negative real yield. However, this is an unusual situation that doesn’t last very long.

• There are studies that have shown that treasury inflation-protected bonds have very little correlation with the actual yields in the market. This is because these bonds work by locking up real yields for a long period of time.

  For instance, a TIPS bond could fix the yield at 3% per annum over the next ten years. However, the fact of the matter is that real yields are not fixed. They too fluctuate with time. Hence, in such cases, if the real yields actually increase, investors have to take a negative hit on their portfolios.

  Also, even though there are some amount of TIPS securities that are available for the short term, most securities have are available over a longer-term and hence leave investors exposed to fluctuations in real risk.

• Another important factor to keep in mind is that in most countries, the consumer price index is an abstract and theoretical construct. This means that even though it is actually meant to calculate the inflation rate, the calculation is often quite inaccurate. This means that it is possible that the CPI might reflect the inflation rate at 3% whereas the inflation rate actually maybe 6%. Hence, it can be said that investors are not completely protected from inflation even if they buy TIPS.

• There have been many historical studies conducted that compare the returns provided by inflation-protected securities with the returns provided by regular securities of the same risk and maturity.

  The empirical record is crystal clear on the fact that inflation-protected securities earn a significantly less yield as compared to regular securities.

The bottom line is that treasury inflation-protected securities work as very expensive inflation insurance for investors. They are useful for some investors who do not want to take any risk of a fall in purchasing power of their money. However, for the vast majority, these bonds provide sub-optimal returns.

However, despite their shortcomings, treasury inflation-protected securities, continue to enjoy widespread demand. This is why the United States government can afford to issue TIPS bonds that issue negative yield in real terms.