The value of a fixed income bond’s cash flow, both semi-annual coupon and the repayment of principal at maturity can be eroded over time due to inflation. In 1997, the Treasury started auctioning Treasury Inflation Protected Securities (TIPS). Just like treasury securities they bear a fixed coupon rate along with a stated maturity and they are backed by the full faith and credit of the US Government. The first TIP auction was a 5 year maturity. Later in 1997 a 10yr TIP was auctioned and by 1998, 30 year maturity TIPS became part of the Treasury’s regular auction cycle. The essence of a TIP security lies in the fact that the underlying principal amount is adjusted for the monthly changes in inflation as measured by the non-seasonally adjusted Consumer Price Index (CPI). If inflation goes up, principal increases. Conversely, if deflation occurs, principal decreases. Increasing principal over time increases the income from the fixed rate coupon calculation. In addition, having a greater face amount (principal value) at maturity offsets the financially eroding effects of inflation.
By way of example in its simplest form, if inflation was running at 5% and you purchased a $10,000 TIP at par with a 2% coupon, over time, the face value would adjust upward by 5% to $10,500 which you would receive at maturity. The annual coupon income based of off face value would rise to $210, ten dollars more than you would receive with no inflation adjustment. In a deflationary environment, the principal value can be adjusted downward, but you will never receive less than the original face value at PAR at maturity.
While the exact price/yield of a TIP may not perfectly reflect current inflation due to lag effects of the reference CPI, an approximation of what future inflation is expected to be is reflected in the yield differential between a TIP and the yield of a similar maturity nominal treasury security. In today’s markets the current treasury 10yr note yields 2.50%. The comparable maturity 10yr TIP yields .47% (47 basis points). The difference between the two yields, 2.03%, represents what the market has priced in for inflation over the next ten years. If you believe that inflation will be higher than 2%, then purchasing the ten year TIP would give you a better inflation adjusted return than the nominal treasury. Currently, 5year TIPS are reflecting 2.08% inflation over the next 5 years.
The Federal Reserve Bank as part of their regular FOMC meetings has noted that inflation is moving higher, albeit gradually. In addition, the Trump administration appears poised to provide fiscal stimulus that has been absent for many years. Along with the expectation of accelerating economic growth, comes the expectation for higher inflation. In this environment both the relative total return performance of TIPS coupled with their inflation hedging properties create an opportunity to hold a portion of treasury exposure in TIPS.