How TIPS Work ?

Treasury introduced TIPS in January 1997. They pay a constant rate of interest on an accrued balance which is adjusted daily for changes in the Consumer Price Index (CPI-U). The inflation adjustment is paid when the bonds mature or when they are sold. The "effective yield" is approximately the coupon yield plus inflation.

Let's examine the performance of a one such bond, specifically the 10-year = 3.5% TIPS sold at 99.818 on January 15, 2001, CUSIP 9128276R8. Each thousand dollar par bond cost $998.18 when issued. To calculate the first interest payment, we need the inflation adjustment on
the first payment date, July 15, 2001. The IRD calls the adjustment the "index ratio" since the factor is the ratio of the Consumer Price Index on the date of interest to the value of the Index on the date the bond was issued.

Using the on-line source referenced in endnote 3, the index ratio is 1.01848. The accrued principal balance on the first payment date is the par value of the bond times the inflation factor.

$1000 x 1.01848 or $1,018.48.

The first semi-annual interest payment is $1,018.48 x 3.5% / 2 or $17.82. The index ratio is 1.02022 when the second interest payment is paid on January 15, 2002. The accrued principal balance is $1,020.22 and the second interest payment is $17.85. Subsequent interest payments are calculated in the same manner. If inflation were 3.3% annually over the life of this 10-year bond5, the accrued principal balance at maturity would be

$1000 x (1 + 3.3%) ^ 10 or $1,383.58.

The bonds would be redeemed for $1,383.58 per bond and the final semiannual interest payment would be $24.21. Investors receive a Form 1099-INT reporting the interest paid during the year and a Form 1099-OID reporting the inflation accrual. For 2001, the 1099- INT would report $17.82 per bond.

The inflation accrual is the accrued principal at the end of the year less the accrued principal at the beginning of the year or on the purchase date, if later. The bond is valued at par in these calculations.

The index ratio at year-end 2001 is 1.021116. The ratio was 1.0000 when the bond was issued. The inflation accrual was $21.11 during 2001 $1000 * 1.02111 minus $1000 * 1.00000 = $21.11
and the 1099-OID would report this amount per bond.
The federal tax is calculated on the sum of the interest received plus the inflation accruals7. Interest on TIPS is free of state income taxes unless held in a retirement account.

TIPS Offer More Return. Yield to maturity (YTM) is the annualized pre -tax return of a bond purchased at the current market price and held to maturity. YTM will seldom be the same as the coupon yield because bond prices rise when interest rates decline and vice versa.

YTM on conventional bonds reflect many factors, including the market's estimate of future inflation. YTM on TIPS reflect similar factors except that inflation is not part of the equation. Thus the difference in yields is a rough measure of the market's forecast of future inflation.
Conventional Treasury bonds of intermediate maturities have been priced to yield 1 - 2% more than TIPS during the past five years. FYI, historical inflation has been 2.4% over the five years ending May 2003. The differential between long TIPS and long bonds has been 1.5 - 2.5%.

In essence, bond professionals have been betting that inflation will be less than 1 - 2% in the intermediate term and less than 1.5 - 2.5% over the long term.

If an investor agrees with these forecasts, TIPS are fairly priced compared to conventional Treasury securities. If an investor is concerned that future inflation might exceed these forecasts, TIPS are the better deal. To compare TIPS to bonds with different marginal tax rates, we need to compare after-tax returns. The after-tax return of a conventional bond is
approximately YTM times one minus the marginal tax rate.

YTM x (1 - Marginal Tax Rate)

The after-tax return on TIPS is approximately the sum of YTM plus the assumed inflation rate times one minus the marginal tax rate.

(YTM + Inflation Rate) x (1 - Marginal Tax Rate)