In the bond fundamentals chapter, we learned about the risks of inflation. Fixed income securities (preferred stock and bonds) are particularly susceptible to inflation. Think about it - if you owned a $1,000 par, 5% bond, it would pay you $50 a year in interest. While $50 can buy a fair amount of small items today, it’s very possible $50 wouldn’t buy an average sandwich from a deli in 20 years if high levels of inflation occurred.
Now, let’s think in bigger numbers. Assume a retired investor buys a large number of bonds and currently receives $50,000 in annual interest. They need this amount of money in 2020 to pay for living expenses. At an annual inflation rate of 3%, 20 years later they’ll require roughly $90,000 of annual income to keep pace with inflation. If the investor bought a bunch of 20-year fixed-interest rate bonds, their bonds pay the same $50,000 of fixed interest annually. This is a problem for bond investors!
To keep pace with inflation, investors can keep a portion of their portfolio invested in the stock market, which tends to outpace inflation over long periods of time. If the stock market is too risky for the investor, they can consider investing in TIPS.
Treasury Inflation Protected Securities (TIPS) are long-term debt securities issued by the US Government that pay semi-annual interest to investors. Unlike securities like Treasury bonds, TIPS make higher payments when inflation rates rise. To better understand TIPS, let’s discuss a specific example:
30-year TIPS issued
TIPS are typically issued at par with a fixed coupon. In our example, the 30-year TIPS have a 3% coupon, which is always fixed (doesn’t change). At issuance, these securities are set to pay $15 twice a year ($30 in annual interest). To compensate for inflation, the principal (par) value changes over time. Every six months, TIPS make an adjustment based on Consumer Price Index (CPI) levels. As a reminder, CPI is the government’s measure of inflation as measured by the U.S. Bureau of Labor Statistics. Every month, they capture price changes of goods and services across the United States.
When CPI is rising, inflation is rising. When inflation rises, TIPS make higher interest payments. For example, let’s take a look at what happens when inflation rises by 2% in six months.
30 year TIPS adjustment (+2% CPI)
Because inflation rates increased, the bond makes a higher semi-annual interest payment. While the coupon (3%) stays fixed, the adjusted principal value results in higher semi-annual interest payments. With the inflation rate rising by 2%, so does the par value (2% of $1,000 = $20). Now, the bond pays 3% of $1,020, which is $30.60 annually. We’re focusing on the semi-annual interest payment, which is half of that - $15.30.
This adjustment occurs over the TIPS lifetime. TIPS are issued in 5, 10, and 30-year maturities, so the adjustment process can result in large par values over long periods of time. At maturity, the investor will always receive the greater of the original par value (typically $1,000) or the adjusted par value. This is a great benefit to the investor as they’ll receive a higher payout at maturity if inflation has risen.
While inflation is much more common, deflation can and does occur. Instead of prices rising, deflation results in lower prices. This may sound good on the surface, but it’s a problem for the economy. Your grocery store bill may be falling during deflationary periods, but so does your paycheck and other forms of revenue. Plus, deflation tends to delay businesses and people from spending money, driving down economic output. If you needed to buy a car, why would you do it right now if prices are falling? Waiting may result in a much lower price tag. This may be great for you personally, but it leads to businesses having large inventories they can’t sell. See how it can be a problem?
When deflation occurs, TIPS adjust as well. Let’s assume our previous example from the start:
30-year TIPS issued
What would be the result if CPI reported a 4% annual fall in prices? Specifically, what is the adjustment to the par value and the next interest payment?
With an annual falling CPI rate of 4%, the par value adjusts after 6 months at a rate of -2% (half of the annual 4% decline). 2% of $1,000 is $20, so the par value will fall to $980.
Now, calculate the fixed coupon (3%) based on the adjusted par value ($980). This results in a new annual rate of $29.40, leading to semi-annual interest payments of $14.70 ($29.40 / 2).
The rule regarding adjusted principal at maturity is especially useful in deflationary environments. Even if the adjusted principal is far below the original par ($1,000 in our example), the investor always receives the greater of the original par value or the adjusted principal.
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