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TIPS

TIPS are Treasury Inflation Protected Securities, a type of bond that is issued by the Treasury Department.

Expanded Definition

TIPS are auctioned with 5, 10 and 20 year maturities. Secondary market TIPS can provide a selection of maturity dates.

Here is the Treasury's information page about TIPS:

http://www.treasurydirect.gov/instit/marketables/tips/tips.htm


Like all Treasury bonds, TIPS are backed by the full faith and credit of the U.S. government. TIPS interest is subject to federal income tax, but is state and local tax exempt.

TIPS can be bought on the auction date either from Treasury Direct or from a brokerage. TIPS can also be bought on the secondary bond market any time.

The coupon yield of the TIPS is set on the auction date.

Interest payments are calculated by applying the coupon rate to the principal.

This is what makes TIPS different from most other bonds: TIPS principal isn't fixed.

The principal of the TIPS is adjusted by changes in the Consumer Price Index for Urban Consumers (CPI-U). The coupon yield is applied to the inflation-adjusted principal for the interest, which is paid every 6 months.

Because TIPS are inflation adjusted, their price is more stable than ordinary Treasury bonds, whose value drops if inflation rises above the predicted inflation rate. TIPS price movements are based solely on interest rate movements, since they are adjusted for inflation.

The difference between the yield of a Treasury and a TIPS of the same maturity indicates the market's prediction of inflation over that duration, because Treasuries and TIPS are equally safe.

If you believe that inflation will be higher than the predicted inflation rate over the duration of the bond, you should buy TIPS instead of Treasuries.

Current yields on Treasuries and TIPS can be found at:

http://www.bloomberg.com/markets/rates/

Auction dates for TIPS can be found at:

http://www.treas.gov/offices/domestic-finance/debt-management/auctions/auctions.pdf

TIPS can be bought on the secondary market from many brokerages. When you buy a seasoned TIPS, you will pay more than the original issue price, because the principal has been adjusted by inflation. This is called the "Original Issue Discount" or OID. When the bond matures, or you sell it, you will receive the inflation-adjusted principal. The inflation adjusted principal is based on the Daily Index Ratio of the CPI-U.

Historical Reference CPI Numbers and Daily Index Ratios

http://www.treasurydirect.gov/instit/annceresult/tipscpi/tipscpi_hiscpi.htm

If deflation occurs, the Daily Index Ratio will go down, causing the principal to go down. The value of seasoned TIPS will decline in deflation. However, the principal of the TIPS at maturity can never decline below its issue value. If you anticipate deflation, it's better to buy regular Treasuries -- or to buy TIPS at auction, not on the secondary market.

Like all bonds, the price of a secondary market TIPS will rise if prevailing interest rates fall, and fall if prevailing interest rates rise (and also with market supply and demand).

The historical data of market yields for TIPS bonds (and other Treasuries) of various maturities can be found at:

http://www.federalreserve.gov/releases/h15/data.htm

Between 1/3/2003 and 6/12/2009, the market yield of the 10 year TIPS (constant maturity) fluctuated between 0.99% and 3.07%, with an average of 1.99%.

Between 1/3/2003 and 6/12/2009, the market yield of the 10 year Treasury (constant maturity) fluctuated between 2.18% and 5.22%, with an average of 4.18%.


The standard deviation of the TIPS over this period was 0.36%, while the standard deviation of the 10 Year Treasury was 0.58%. This shows that the TIPS yield is more stable than the Treasury yield.

Between 1/2003 and 5/2009, the Treasury - TIPS spread was consistently lower than the inflation rate. This shows that the bond market underestimates inflation. TIPS owners would receive higher yield to maturity than Treasury owners when this happens. If inflation is "higher than expected" in the future, TIPS owners will be compensated, while Treasury owners will suffer.

http://boards.fool.com/Message.asp?mid=27755993

The Treasury Inflation Protected Security is one of the safest, most stable investments available. It protects the value of the investment from inflation, while providing a small yield.

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