About TIPS Funds - What does this mean?

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JSparks
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About TIPS Funds - What does this mean?

Post by JSparks »

Sorry for the stupid question, but what does it mean that "inflation-protected security funds are trading at a negative yield to maturity before inflation"? Does this even matter for an investor with a long horizon?
strakert
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Re: About TIPS Funds - What does this mean?

Post by strakert »

JSparks wrote: Sat Oct 16, 2021 11:58 am Sorry for the stupid question, but what does it mean that "inflation-protected security funds are trading at a negative yield to maturity before inflation"? Does this even matter for an investor with a long horizon?
The Treasury releases TIPS in an auction process. The returns for TIPS have two components.
1. A principal that is adjusted upwards [1] by the treasury by the CPI inflation rate every 6 months. I.e. if the principal is $100 and the inflation inflation last 6 months was 2%, at the end of 6 months your principal will be adjusted to $102. This is the inflation protection component and is dynamic.
2. A fixed coupon (interest rate) set by the Treasury at the time the auction based on what the market participants ask for.

Typically TIPS coupon rates are lower than equivalent treasury rates by the amount of expected inflation. E.g. if treasuries have a 3% coupon and current inflation expectation for future is 2.5%, market participants will be willing to accept a 0.5% coupon or so for TIPS, maybe a little less, for future inflation protection. This way the real yields for both will be similar, unless unexpected inflation shows up, in which case TIPS come out ahead.
But this coupon rate can be negative [2] if the market participants are willing to pay a little bit extra to get the inflation protection (their inflation prediction crystal ball is getting cloudy), or if the interest rate for treasuries are below inflation expectation for some reason (e.g. because of a flight to liquidity during crises when everyone is buying treasuries).

Is a negative coupon for TIPS bad? Yes and no. Yes, it sucks that you're guaranteed to lose (a little bit of) money to inflation over time. No, because this is still the best mechanism to protect against unexpected inflation. Note that this issue exists for all other bonds of similar credit quality and duration: they're also losing money to inflation in real terms, it's just not as obvious because their stated yields are nominal, not real. With TIPS, you get what's on the tin.

[1] Or downwards in deflation, but never below the original principal.
[2] Technically the treasury doesn't offer coupon rates below 0.125%, it sells at a premium on par instead. But the overall effect is the same.
Last edited by strakert on Mon Oct 18, 2021 5:56 pm, edited 2 times in total.
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Re: About TIPS Funds - What does this mean?

Post by #Cruncher »

JSparks wrote: Sat Oct 16, 2021 11:58 am... what does it mean that "inflation-protected security funds are trading at a negative yield to maturity before inflation"?
I like to explain yield-to-maturity (YTM) of a bond with the analogy of a savings account. First consider $10,000 of a TIPS with a positive YTM, the 5-year bought at auction October 2019:

Code: Select all

Face value   10,000.00
    Coupon      0.125%
     Price  100.351378
       YTM      0.054%
Instead of buying the TIPS, assume we deposit the $10,035.14 purchase price in a savings account paying 0.054% interest and withdraw the coupon rate every six months. After five years, there would be $10,000 left in the account.

Code: Select all

              Interest  Withdraw     Balance
10/31/2019                         10,035.14
 4/15/2020       2.47     (5.70)   10,031.91 [*]
10/15/2020       2.71     (6.25)   10,028.37
 4/15/2021       2.71     (6.25)   10,024.82
10/15/2021       2.71     (6.25)   10,021.28
 4/15/2022       2.71     (6.25)   10,017.74
10/15/2022       2.70     (6.25)   10,014.19
 4/15/2023       2.70     (6.25)   10,010.64
10/15/2023       2.70     (6.25)   10,007.10
 4/15/2024       2.70     (6.25)   10,003.55
10/15/2024       2.70     (6.25)   10,000.00 <---
Now consider a TIPS with a negative YTM, the 5-year bought at auction April 2021:

Code: Select all

Face value   10,000.00
    Coupon      0.125%
     Price  109.108340
       YTM     -1.631%
Again assume that the purchase price is deposited in a savings account. But with a negative rate (-1.631%), the bank debits the interest every six months instead of crediting it. We still end up with $10,000 in the account after five years.

Code: Select all

              Interest  Withdraw     Balance
 4/30/2021                         10,910.83
10/15/2021     (81.68)    (5.74)   10,823.41 [*]
 4/15/2022     (88.26)    (6.25)   10,728.90
10/15/2022     (87.49)    (6.25)   10,635.15
 4/15/2023     (86.73)    (6.25)   10,542.17
10/15/2023     (85.97)    (6.25)   10,449.95
 4/15/2024     (85.22)    (6.25)   10,358.48
10/15/2024     (84.47)    (6.25)   10,267.76
 4/15/2025     (83.73)    (6.25)   10,177.78
10/15/2025     (83.00)    (6.25)   10,088.53
 4/15/2026     (82.27)    (6.25)   10,000.00 <---
* On the first interest payment date, both the interest and the withdrawal are slightly smaller since the period since the initial deposit (i.e., the settlement date of the TIPS purchase) is less than six full months.
strakert
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Re: About TIPS Funds - What does this mean?

Post by strakert »

#Cruncher wrote: Sat Oct 16, 2021 4:34 pm
JSparks wrote: Sat Oct 16, 2021 11:58 am... what does it mean that "inflation-protected security funds are trading at a negative yield to maturity before inflation"?
I like to explain yield-to-maturity (YTM) of a bond with the analogy of a savings account. First consider $10,000 of a TIPS with a positive YTM, the 5-year bought at auction October 2019:

Code: Select all

Face value   10,000.00
    Coupon      0.125%
     Price  100.351378
       YTM      0.054%
Instead of buying the TIPS, assume we deposit the $10,035.14 purchase price in a savings account paying 0.054% interest and withdraw the coupon rate every six months. After five years, there would be $10,000 left in the account.

Code: Select all

              Interest  Withdraw     Balance
10/31/2019                         10,035.14
 4/15/2020       2.47     (5.70)   10,031.91 [*]
10/15/2020       2.71     (6.25)   10,028.37
 4/15/2021       2.71     (6.25)   10,024.82
10/15/2021       2.71     (6.25)   10,021.28
 4/15/2022       2.71     (6.25)   10,017.74
10/15/2022       2.70     (6.25)   10,014.19
 4/15/2023       2.70     (6.25)   10,010.64
10/15/2023       2.70     (6.25)   10,007.10
 4/15/2024       2.70     (6.25)   10,003.55
10/15/2024       2.70     (6.25)   10,000.00 <---
Now consider a TIPS with a negative YTM, the 5-year bought at auction April 2021:

Code: Select all

Face value   10,000.00
    Coupon      0.125%
     Price  109.108340
       YTM     -1.631%
Again assume that the purchase price is deposited in a savings account. But with a negative rate (-1.631%), the bank debits the interest every six months instead of crediting it. We still end up with $10,000 in the account after five years.

Code: Select all

              Interest  Withdraw     Balance
 4/30/2021                         10,910.83
10/15/2021     (81.68)    (5.74)   10,823.41 [*]
 4/15/2022     (88.26)    (6.25)   10,728.90
10/15/2022     (87.49)    (6.25)   10,635.15
 4/15/2023     (86.73)    (6.25)   10,542.17
10/15/2023     (85.97)    (6.25)   10,449.95
 4/15/2024     (85.22)    (6.25)   10,358.48
10/15/2024     (84.47)    (6.25)   10,267.76
 4/15/2025     (83.73)    (6.25)   10,177.78
10/15/2025     (83.00)    (6.25)   10,088.53
 4/15/2026     (82.27)    (6.25)   10,000.00 <---
* On the first interest payment date, both the interest and the withdrawal are slightly smaller since the period since the initial deposit (i.e., the settlement date of the TIPS purchase) is less than six full months.
Thanks for the clear example #Cruncher!

I was curious why TIPS aren't sold at par so that the coupon rate would be equal to YTM and simplify this discussion. Looks like this is because of 2 policies:
1. Treasury only sets coupon rates in increments of 0.125. It sets it slightly below the YTM from the auction, and lets the buyers receive a discount to par to cover the difference. Presumably to simplify book-keeping?
2. The Treasury has set a minimum coupon rate of 0.125 - it will not go to 0 or negative coupon rates. For negative auction YTM the buyer pays the difference as a premium to par. Presumably to avoid bad optics or simplify book-keeping?
dbr
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Re: About TIPS Funds - What does this mean?

Post by dbr »

To answer the other part of your question, it does matter to any investor that has a long horizon. Now is a bad time in history to establish bond investments for the long run. I bonds are just as bad. The fixed rate is 0%, which might be better than other choices, but historically speaking and perhaps future speaking, that is not a good interest rate.

An example of that would be a person wanting to use 30 years TIPS for a retirement income stream in the form of an LMP ladder. The payback at -2% real for the ladder is 2.4%, at -1% it is 2.9%, at 0% it is 3.3%, and to get 4% you need a ladder with real yields at about 1.5%, at least that is an estimate I once figured out.
tonyclifton
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Re: About TIPS Funds - What does this mean?

Post by tonyclifton »

I think this is listed in the brokerage website to prevent future complaints from people who buy but didn’t know how the negative rate would impact them. Kind of like a buyer beware or “we told you so.”
dbr
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Re: About TIPS Funds - What does this mean?

Post by dbr »

tonyclifton wrote: Sun Oct 17, 2021 12:46 pm I think this is listed in the brokerage website to prevent future complaints from people who buy but didn’t know how the negative rate would impact them. Kind of like a buyer beware or “we told you so.”
I think that is right. If that investor went to TD to buy TIPS at auction he would find himself having to pay more than face value to buy the bond.
For example, for this TIPS a $100 bond would cost the investor $105. He would find that he had placed $105 and would only get back $100 real at maturity. In the meantime the coupon interest rate would be 1/8% https://www.treasurydirect.gov/instit/a ... 0218_3.pdf
FactualFran
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Re: About TIPS Funds - What does this mean?

Post by FactualFran »

strakert wrote: Sun Oct 17, 2021 3:33 am I was curious why TIPS aren't sold at par so that the coupon rate would be equal to YTM and simplify this discussion. Looks like this is because of 2 policies:
1. Treasury only sets coupon rates in increments of 0.125. It sets it slightly below the YTM from the auction, and lets the buyers receive a discount to par to cover the difference. Presumably to simplify book-keeping?
2. The Treasury has set a minimum coupon rate of 0.125 - it will not go to 0 or negative coupon rates. For negative auction YTM the buyer pays the difference as a premium to par. Presumably to avoid bad optics or simplify book-keeping?
Coupon rates in increments of 0.125% is likely a long established policy.

Avoiding a coupon rate of 0% is likely to have as distinct securities TIPS and interest and principal payments that have been stripped from TIPS.

Avoiding a negative coupon rate is likely because the Treasury wants to borrow from persons rather than lend to persons.

There are Treasury securities sold at par. Floating rate notes are sold at par at the original auction. They are not necessarily sold at par at reopening auctions.
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JSparks
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Re: About TIPS Funds - What does this mean?

Post by JSparks »

I still don't understand. So let me make an even bigger fool of myself by asking... does all of this apply to individually bought TIPS only, or does it also apply to TIPS funds?
strakert
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Re: About TIPS Funds - What does this mean?

Post by strakert »

JSparks wrote: Sun Oct 17, 2021 4:46 pm I still don't understand. So let me make an even bigger fool of myself by asking... does all of this apply to individually bought TIPS only, or does it also apply to TIPS funds?
All of this applies to individual TIPS purchased directly from the Treasury. TIPS funds are more complex have a whole other set of issues that are related to individual bonds vs bond funds. Many threads on this, but see this post for an example. If you're asking whether TIPS funds can return less than inflation, the answer is yes, including for reasons *in addition* to the ones already mentioned above!

I'd suggest making a new post stating the problem you're trying to solve and asking for the best way to do that. That way folks will be able to give you a recommendation directly accounting for all of the nuances.
000
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Re: About TIPS Funds - What does this mean?

Post by 000 »

TIPS and all 'safe' fixed income are expected to lose value in real terms, i.e. the yield is less than inflation expectation. In the case of TIPS this is explicit because they have a CPI adjustment.
FactualFran
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Re: About TIPS Funds - What does this mean?

Post by FactualFran »

JSparks wrote: Sat Oct 16, 2021 11:58 am Sorry for the stupid question, but what does it mean that "inflation-protected security funds are trading at a negative yield to maturity before inflation"? Does this even matter for an investor with a long horizon?
It means that the per share fund price is higher than the per share value of the fund due to the par value of the TIPS held by the fund, and the premium (price minus par) is sufficiently high that the future loss due the premium of TIPS going to zero at maturity exceeds the future interest payments without the inflation adjustment.

It matters if an investor is expecting a return greater than or equal to inflation.
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Re: About TIPS Funds - What does this mean?

Post by Whakamole »

000 wrote: Sun Oct 17, 2021 7:38 pm TIPS and all 'safe' fixed income are expected to lose value in real terms, i.e. the yield is less than inflation expectation. In the case of TIPS this is explicit because they have a CPI adjustment.
If this is the case, and we consider bonds as "ballast" rather than an income-producing asset, does it make sense to hold anything other than TIPS or TIPS funds? If we're always losing money to inflation, it's better to be explicit.

I realize that bond funds once were income-producing but that hasn't been the case for a while, and the value of bonds only went up after interest rates started to plummet in the early 80s.
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Re: About TIPS Funds - What does this mean?

Post by Dude2 »

Whakamole wrote: Tue Oct 19, 2021 9:02 am
000 wrote: Sun Oct 17, 2021 7:38 pm TIPS and all 'safe' fixed income are expected to lose value in real terms, i.e. the yield is less than inflation expectation. In the case of TIPS this is explicit because they have a CPI adjustment.
If this is the case, and we consider bonds as "ballast" rather than an income-producing asset, does it make sense to hold anything other than TIPS or TIPS funds? If we're always losing money to inflation, it's better to be explicit.

I realize that bond funds once were income-producing but that hasn't been the case for a while, and the value of bonds only went up after interest rates started to plummet in the early 80s.
In those olden days bygone, people certainly were just as blind dealing with "money illusion" as we are today. The idea of income production via bonds was probably largely money illusory. The industry still hasn't lost the jargon, and you hear it around the forum still. All that matters is total return, risk, volatility. You create a pile of money for retirement, and then you start drawing it down. Whatever concept there is related to income production doesn't hold any water -- then or now.
Then ’tis like the breath of an unfee’d lawyer.
strakert
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Re: About TIPS Funds - What does this mean?

Post by strakert »

Whakamole wrote: Tue Oct 19, 2021 9:02 am
000 wrote: Sun Oct 17, 2021 7:38 pm TIPS and all 'safe' fixed income are expected to lose value in real terms, i.e. the yield is less than inflation expectation. In the case of TIPS this is explicit because they have a CPI adjustment.
If this is the case, and we consider bonds as "ballast" rather than an income-producing asset, does it make sense to hold anything other than TIPS or TIPS funds? If we're always losing money to inflation, it's better to be explicit.

I realize that bond funds once were income-producing but that hasn't been the case for a while, and the value of bonds only went up after interest rates started to plummet in the early 80s.
See thread: Why use anything but TIPS? where many come to the conclusion that it is reasonable to hold only TIPS.
TL;DR: They will underperform Treasuries if the actual inflation turns out to be lower than what was expected at auction. And their nominal value will decrease during deflation (but will not go below original principal) whereas similar Treasuries will go up. But if your goal is to maintain the same amount of capital in real terms instead of seeking high total yield, they (and I-Bonds) are the best tool for the job. You should think about whether this inflation insurance is a good goal for you.
000
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Re: About TIPS Funds - What does this mean?

Post by 000 »

Whakamole wrote: Tue Oct 19, 2021 9:02 am If this is the case, and we consider bonds as "ballast" rather than an income-producing asset, does it make sense to hold anything other than TIPS or TIPS funds? If we're always losing money to inflation, it's better to be explicit.

I realize that bond funds once were income-producing but that hasn't been the case for a while, and the value of bonds only went up after interest rates started to plummet in the early 80s.
strakert linked to the thread about your question. Personally I am not a fan of a 100% TIPS bond portfolio. If I were to make a long term buy and hold investment in bonds, I think I would like some deflation counteraction and some higher yield corporates.
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