Treasury inflation-protected securities

are often called tips for short tips are a type of government bond that accounts

for the fact that prices of goods and services change over time they call this

inflation let’s look a bit closer first let’s imagine that you bought $1,000 of

a typical 30 year Treasury bond and this bond pays interest at a rate of 3% per

year this is called the nominal interest rate nominal simply means the interest

rate you receive before inflation if you adjust the interest rate by inflation

well they call this the real rate of return so you can calculate the real

rate of return by simply taking our three percent and subtracting inflation

as measured by the consumer price index often called CPI so if the CPI shows

that inflation went up by let’s say 2% while our real rate of return for these

government bonds is just 1% but here’s where it gets interesting

to illustrate inflation movements here’s an actual chart of the CPI since the

1950s and yes inflation went a bit nuts in the 70s and early 80s but you can see

that inflation hit almost 4% as recently as 2011 and 5% in 2008 so what are the

alternatives this is where tips or Treasury inflation-protected securities

step in you can buy tips for 5 10 or even 30 year terms but let’s stick with

our 30-year example so you invest the same 1,000 dollars in tips and let’s

imagine that this 30-year tips will pay the same 3% as the regular bond it

wouldn’t but we’ll come back to that in a minute so you pay the $1,000 this has

a few names it can be called it can be called principle or face value or even

par value so the face value is your month it’s going to be paid back to you

when the bonds life ends in this case 30 years from now the 3 percent well this

is how much needs to be paid to you the investor each year but government bonds

actually pay interest twice a year so that 3% on the $1,000 is $30 per year

which is $15 every six months simple enough

now this math is true for both regular bonds and TIPS but what about inflation

so let’s imagine that after the first year inflation was 2% well what makes

tips unique is that the face value in our case

the $1,000 is adjusted by the inflation rate so now our face value is

1020 dollars went by tips the interest rate you received when the bond was

issued is locked but the interest payments paid is a reflection of both

the fixed interest rate and the face value of the bond that is adjusted with

inflation so now the 3% interest payment the government owes you is 30 dollars

and 60 cents divide that by 2 to account for the two

payments in a year and you get 15 dollars and 30 cents for this

semi-annual payment so what’s the catch well first off in our hypothetical

scenario we had both a traditional 30-year bond pay 3% and the Treasury

inflation-protected securities a percent the only way this would really happen is

if inflation is expected to be 0% and that’s extraordinarily unlikely sticking

with more realistic numbers it’s more likely that inflation is expected to be

let’s say 2% this would mean that the traditional bond would pay an interest

rate of 3% while tips would pay an interest rate of 1% this accounts the

expected inflation rate so with this in mind our tips worth it well it depends

what’s the average inflation rate for the life of the bond if the inflation

rate over the 30 years averaged more than 2% which is the initial spread

between the traditional and tips well the tips would have a greater total

return if the average rate was less than 2% but the total return would be less

than traditional bonds if inflation was exactly 2% well the total return would

be the same they call this 2% the break-even rate now what about deflation

deflation is when the inflation rate is negative well if deflation occurs the

bond value decreases so if the face value was 1,000 dollars and then the

inflation rate was negative 1 percent while the $1000 would fall by 1% or 10

dollars so now our face value is just 990 dollars and let’s imagine that

deflation stuck around for a little while and although you invested $1,000

at the start your tips term is coming to an end

and currently they have a face value of just 950 dollars what happens when you

go to get repaid your bonds face value well the government will repay you the

full one thousand dollars the rule is that you will be repaid the current face

value or par value par value is the initial face value of the bond in our

case one thousand dollars so if your face value had climbed all the way to

let’s say twelve hundred dollars and the deflation occurred knocking your face

value down to let’s say 1150 well you will be repaid the 1150 since that is

higher than the original par value and for our final point let’s take a quick

look at taxes with either tips or traditional bonds your interest payments

every six months are subject to federal income tax but with tips the adjustment

to the face value due to inflation is also subject to tax which means that if

inflation was the original 2% we mentioned and our $1000 face value was

adjusted higher by that 2% giving us a $20.00 gain well will be taxed on that

$20.00 gain even though we will not be given the $20.00 until the end of the

bonds life they call this phantom income if deflation occurs while our phantom

losses can now be used to offset our taxes if you have any questions about

the world of investing any suggestions on videos please post in the comments

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week thank you

Have you ever invested in TIPS? Would you?

I have never invested in TIPS, but now I would. Good video. Interesting option I never knew much about!

Great video! Well done! Thanks!

dude awesome thanks!

So, if inflation is 2% first year and 3% second year with a interest rate of 1%, we have a (1000 × 1.02) 1020*0.01=10.2 interest first year.

And a (1020×1.03) 1050.6×0.01=10.506 interest the second year.

Right?

How do you file tips in your taxes ?

Is it just in this case that the breakeven rate is 2% ?

So if inflation became ridiculously high like 8-10%, and you owned a fair bit in TIPS, you would be paying a substantial amount in taxes without getting a lot back? (assuming the TIP still has a long life)

TIPS have been offered for about the last 6 years to many in State admin

as part of their 457 and 401k. Their returns have been horrible and especially due

to high cost ratios that eat up their returns. However, as I am writing this in Sept 2019

I am a huge fan of TIPS and think they will do very well for the next few years in providing

protection.