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Thursday, April 06, 2006

 

Why TIPS?

Treasury Inflation Protected Securities (TIPS) are a new type of bond class that have been available since late 1990s. Their total return has two parts: real return based upon current interest rate environment, and inflation adjustment of principal based upon CPI-U (urban). Food and energy are included in CPI-U, unlike the core CPI that excludes them.

Difference between the current yield of regular treasuries (T-Notes/Bonds) of comparable maturities and TIPS current yield is the current inflation expectation for future. If the actual inflation turns out to be more that the current inflation expectation, then you win with TIPS; otherwise, you win with regular treasuries.

It is then possible to mix regular treasuries and TIPS to create an inflation neutral bond portfolio.

You can hold TIPS in brokerage accounts, Treasury Direct accounts, or as mutual funds. If you hold individual TIPS bonds, then you get 1099-INT for annual interest, and 1099-OID for annual inflation adjustment of principal; you have to pay federal income tax on both even though you don’t get cash payout for annual principal adjustment. It is therefore preferable to hold TIPS bonds in tax advantaged accounts. If you buy TIPS mutual funds, then the funds pay out interest and principal adjustments as annual distributions.

A related product is I-Bonds. It has a fixed base rate and inflation adjustment based upon CPI-U. Uncle Sam has been stingy in setting I-Bond base rate. In the current low interest rate environment, don’t buy EE-Bonds because now their rate is fixed at the time of purchase. Many people who have been buying EE-Bonds through payroll deductions have not realized that rules have been changed for worse. A great advantage of Savings Bonds is that they don’t generate any paper trail and only you and Treasury, and IRS at the time of sale, know about them. This is a good way to stash away some money that a spendthrift or problem partner knows nothing about.

YogiBB



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