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July 1997

eCONOMIC
COMMeNTORY
Federal Reserve Bank of Cleveland

TIPS for Safer Investing
by Kevin H. Sargent and Richard D. Taylor

Inflation - a persistent increase in the
price level- threatens people's financial
well-being by reducing the purchasing
power of money, cutting into the future
value of savings, and, when unexpected,
lowering the real rate of return on investments. 1 To protect their holdings, people take great pains to find investments
whose returns exceed the inflation rate,
such as stocks, bonds, and numerous
other financial instruments. But when
their returns are corrected for inflation,
investors often see negative numbers.
Prominent economists such as Milton
Friedman, James Tobin, and Stanley
Fischer have long endorsed the idea of
indexing government securities to
changes in the price level. 2 But even as
Great Britain, Canada, Australia, and
Sweden were doing just that, the U.S.
Treasury remained reluctant to follow
suit- until last year.
On May 16, 1996, the Treasury Department made financial history by announcing its intention to issue the first U.S.
securities indexed to the rate of inflation.
Dubbed Treasury Inflation-Protection
Securities (TIPS), the indexed bonds
were first auctioned on January 29,
1997. Now, U.S. investors and savers
can purchase a financial instrument that
provides a guaranteed hedge against the
loss of purchasing power that accompanies increases in the Consumer Price
Index (CPI).3

ISSN 0428- 1276

The Treasury's about-face on TIPS was
motivated by its desire to broaden the
choice of debt instruments available to
the American public and to reduce the
Treasury's borrowing costs.4 Although
most professionals in the investment
community and academia appear to back
the Treasury's decision, their support
stems almost entirely from the belief that
TIPS will fill an important niche in
American investors ' portfolios. Considerable disagreement exists about the
Treasury 's ability to reduce its borrowing costs.
This Economic Commentary reviews
TIPS ' key structural features and discusses some of their advantages and disadvantages relative to other investment
alternatives. It also looks at the potential
benefits to the Treasury. When all of
these elements are weighed, it is clear
that TIPS are a much-needed financial
innovation that will help investors protect themselves against the negative
effects of inflation.

•

A Review of TIPS' Structure

TIPS are structured similarly to the realreturn bonds currently issued in Canada.
The value of the principal is adjusted for
inflation each day, using changes in the
CPI as a benchmark. 5 Every six months,
a fixed-rate coupon is issued, with its
payment based on the revised principal
amount. The Treasury is currently issuing TIPS on a quarterly basis and uses a
single-price auction to determine the
fixed -rate coupon on each new issue.6

-

Treasury Inflation-Protection Securities, or TIPS, are the first U.S. government securities guaranteed to provide
riskless, long-term protection against
unexpected inflation. Benchmarked
against changes in the Consumer
Price Index, TIPS should attract various types of investors, including those
who do not want to risk their money
in the stock market, those who need to
draw on their investment while preserving their principal, and small
investors who might not otherwise be
able to shelter their savings from
inflation's ill effects.

A TIPS principal grows at the same rate
as inflation; thus, it maintains its real
value in terms of the market basket of
goods that make up the CPI. The fixedrate coupon also rises in proportion to
the increase in the principal. If deflation
occurs, the principal is adjusted down in
accordance with the falling CPI, as is the
coupon payment. It is possible, then, that
the coupon could pay on a principal
amount less than par (the stated value of
the security at issuance). The principal is
returned to the investor upon maturity,
fully adjusted for inflation (or deflation).
However, if deflation reduces the principal below par, the investor will still
receive par back from the Treasury.7
In contrast to TIPS, standard Treasury
securities have a fixed principal amount
and a fixed coupon payment. The investor receives a biannual coupon payment,
which is based on the fixed principal.
When a standard Treasury security matures, the investor receives par, or the
face value of the bond. The Treasury intends to continue issuing TIPS in several
maturities ranging from one to 30 years.8

•

Limited Alternatives

It is generally agreed that investors and
savers benefit from having more financial instruments at their disposal. Although returns on TIPS are expected to
be lower than on traditional Treasury
securities, many economists believe that
there is a group of people who will
gladly forgo a higher rate ofreturn for
the guarantee that their savings will keep
pace with inflation.

Before TIPS became available, hedging
against the ri sk of changes in the price
level meant assuming other risks. Small
investors found it costly to obtain the
proper diversification to hedge against
inflation once management and brokerage fees were added in, and even then
there was no guarantee of full protection
from its effects.
Residential property is sometimes considered an effective inflation hedge, but
it is not tied directly to the CPI and is not
affordable for some investors. Gold and
other commodities are also imperfect
hedges because they, too, do not precisely mirror the CPI.

Stocks are considered very poor protection against a rising price level, because
higher prices tend to bring about lower
nominal and real yields. 9 Stock market
fluctuations complicate matters because
a market downturn can occur at the same
time an investor needs his money. Rolling over short-term Treasury bills is generally believed to provide an adequate
hedge against inflation, but this exposes
the investor to fluctuations in the real
interest rate. 10 A person who invests in
TIPS and holds them to maturity will not
experience this market risk.
With no other financial instrument available to provide riskless, long-term protection against unexpected inflation,
TIPS should be attractive to those investors and savers who are willing to accept
lower returns for greater peace of mind.
They will also provide costless inflation
protection to small investors who might
not otherwise be able to acquire it.

•

Why Choose TIPS?

To understand why TIPS are important
innovations for U.S. investors, it is helpful to examine the ex ante (expected) and
ex post (actual) real rate ofretum on
nominal Treasury securities over time.
Figure 1 shows the real ex post rates of
return on a 10-year nominal Treasury
bond and a 10-year TIPS (assuming one
had been available) that have earned a
fixed rate of3 percent since 1963. In
other words, each data point represents
the result of an investment that was made
10 years earlier and held until maturity. 11
Interestingly, investors who purchased a
10-year Treasury bond in the late 1960s
lost a significant amount of purchasing
power on what were-and still areconsidered "safe" fixed-income investments. Over the entire period, the real
rate ofreturn on nominal bonds ranged
from - 1.6 to 9.5 percent. Furthermore,
nominal Treasury bonds yielded negative real returns for virtually the entire
high-inflation decade of 1974 to 1984.
Because we cannot precisely measure
the ex ante real rate of return demanded
by investors, we cannot pinpoint how
TIPS' returns would have fared against
nominal bonds. However, we can be certain that TIPS' yields would not have

been negative, as were the real yields on
traditional bonds during certain highinflation episodes over this period.
Clearly, no rational investor would accept a negative real rate of return, but
that is exactly what happened to those
who failed to anticipate the double-digit
inflation of the late 1970s and early
1980s. The low-inflation environment of
the 1960s led most long-term investors
to believe that inflation would not reach
the levels it eventually did, just as many
investors today might feel that they are
safe from any future surges.
Despite the Federal Reserve's success at
holding down inflation since the midl 980s, there is no guarantee that the CPI
will not creep back up to previous levels
-or higher. We can never be sure what
shocks might hit the economy. Our current low-inflation environment looks
very similar to that of the 1960s, but the
period in between was marked by several
shocks and policy moves that caused
prices to soar. TIPS will protect investors
if inflation begins to rise again.

• Performance: TIPS
versus Treasuries
The performance of TIPS compared to
nominal Treasury securities depends on
the actual rate of inflation relative to expectations. If actual inflation ends up
being less than what the market anticipates, TIPS will underperform conventional Treasury securities. Conversely,
if actual inflation exceeds expected
inflation, TIPS will pay a higher rate of
return than conventional Treasuries. The
main difference hinges on the accuracy
of the market's predictions about future
inflation. If inflation forecasts prove to
be correct, then in theory, TIPS' performance will lag that of traditional
Treasuries because the return on the latter includes a premium for inflation risk.
However, because TIPS have liquidity
problems (discussed in the next section),
the difference in returns will depend on
the relative sizes of the inflation risk and
liquidity premiums.

FIGURE 1 EX POST AVERAGE ANNUAL REAL RETURNS

8

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996

SOURCE: Authors' calculations.

FIGURE 2 BREAK-EVEN POINTS FOR SELECTED INFLATION
AND MARGINAL TAX RATES

expenses such as a child's college education or future medical bills. Increases in
the prices of these two items have far
outpaced the rate of general CPI inflation
over the past 20 years. In the 1980s, college costs rose at an average annual rate
of9.5 percent and medical expenses
advanced 8.3 percent, compared to an
increase in the overall inflation rate of
5.6 percent. This trend has continued in
the 1990s. If investors had been using
TIPS to save for college or medical care
over the past two decades, they would
still be behind in real terms. TIPS are a
true inflation hedge only if the investor's
objective is to use the matured funds to
purchase a variety of goods as represented by the CPI.

•

Liquidity Concerns

Taxes, an important aspect of any investment, are particularly interesting in
regard to TIPS. An investor who holds
TIPS is taxed annually on the coupon
payments and on the inflation adjustments to the principal. Although TIPS'
returns are not exposed to taxes any
more than any other investment, investors do not receive the total payment that
is being taxed. They receive the fixed
percentage coupon but not the capital
gain on the principal.

Coupon payment and tax liability, dollarsa
120

60

11
13
15
Annual inflation rate, percent

17

19

21

23

a. Based on TIPS ' original $1 ,000 principal.
SOURCE: Authors' calculations.

The United States has experienced several episodes in which inflation exceeded
expectations by a significant margin. Had
an inflation-indexed security been available to investors during those times, its
performance would have been superior to
that of traditional Treasuries.
From April 1963 to August 1997, TIPS'
assumed annual real return would have
been 3 percent, far above the traditional
bond 's 1.67 percent average. 12 In fact,
TIPS would have outperformed the
·traditional Treasury bond in every part
of this period except for the bonds purchased in the late 1970s and early
1980s, when high expected inflation

produced double-digit coupon rates for
traditional Treasuries. When actual
inflation finally began to fall in 1981,
Treasuries continued to pay these high
rates. Had TIPS been available, their
principal growth would have diminished. Still, with a guaranteed return
above the rate of inflation and the backing of the U.S. government, TIPS would
have been a good investment choice
over the past three decades.

One Caveat
What if an investor is saving for an item
whose price is rising faster than the average price of the goods that make up the
CPI's market basket-? Government securities are often used to save for major

It is possible, then (based on the bond
holder 's marginal tax rate), that the investor's tax bill will exceed the coupon
payment if the inflation rate is high
enough (see figure 2). This poses a
cash-flow problem for investors who
might have to draw down another
source of income to pay their taxes.
Investors lacking alternative sources of
cash may be forced to liquidate some
of their holdings, which could expose
them to market risk and possible losses.
All of this is moot, however, if holdings
are kept in a retirement account such as
a 40l(k) or IRA, which allows tax
obligations to be deferred.

Despite a successful initial Treasury
auction for TIPS, liquidity is still a concern for many investors. Traditional
long-term government securities have a
total dollar value of $2. 7 trillion outstanding; for TIPS, that figure is only
about $16 billion. TIPS' trading activity
is also sporadic, amounting to as much
as $100 million on some days and nothing on others. In contrast, traditional
10-year Treasury notes average about
$4 billion a day in trading. TIPS' volatility and low volume make short-term
trading a particularly risky venture. For
countries and large corporations that
deal in U.S . government debt and need
a great deal of liquidity to move in and
out of their positions, TIPS may not
provide the required liquidity at this
time. Perhaps as the Treasury auctions
new issues, thereby increasing the size
of the market and filling out the term
structure, the bonds will become more
popular with traders.

•

Savings for the Treasury?

When investors purchase a government
bond, they take on several types of risk,
including default, market, inflation, and
liquidity risk. 13 Nominal Treasury
securities and TIPS carry the same
degree of default and market risk. TIPS,
however, entail no inflation risk and
currently carry more liquidity risk than
traditional Treasury securities.
Because investors expect to be compensated for assuming these risks,
investments carry premiums that vary
according to their risk characteristics.
Relatively safe, short-term government
securities traditionally come with a
"risk-free" rate ofreturn. But even the
shortest-term government bonds carry a
premium to compensate investors for
the risk of inflation.
On a nominal bond, investors demand
an inflation premium to compensate
them for their expectations about future
inflation. But they also demand a risk
premium to offset the fact that they
must make a guess about future inflation - a guess that could be wrong.

This is where TIPS come into play. By
guaranteeing a rate of return that exceeds inflation, the risk premium is
eliminated and the Treasury can pay a
lower interest rate on the securities.
Also, ifthe public's inflation expectations are higher than what is actually
realized, the Treasury can lower its borrowing costs by bearing the risk of inflation itself. Of course, if the reverse is
true and actual inflation exceeds expectations, the Treasury will end up paying more to the market than it otherwise
would have.

If liquidity continues to be a problem in
the market for TIPS, investors may require a premium as compensation for
bearing additional risk. This could offset any savings the Treasury might have
realized by eliminating the inflation risk
premium.

•

Conclusion

On the other side of the aisle are those
who desire a higher return from their
investments and can stomach the risks
of the stock market. A portfolio invested
in S&P 500 stocks over the past 40
years would have outpaced TIPS by a
significant margin. People who are saving for items whose price generally rises
faster than the CPI may also want to
look into other investments.
The most important point is that Americans now have a new investment vehicle at their disposal. Those who choose
this instrument over others will essentially be exchanging the risk of consumer price movements for the risk of
underperforrning other investment
options. TIPS provide a direct hedge
against increasing prices. They may not
perform well enough to attract some
investors, but they offer a safe haven for
those who want an investment that is
guaranteed to keep pace with inflation .

TIPS are important new debt instruments that enhance the financial menu
already available to U.S. investors. They
are the only guaranteed hedge against
inflation and can provide cheap protection to investors who might not be able
to afford other alternatives.
TIPS are not without risk, however.
The market for them is not yet fully
developed, and the term structure is
incomplete. Those concerned with
liquidity may continue to wait on the
sidelines until TIPS start trading more
consistently and in larger volumes.

I
Who is likely to invest in TIPS? Conservative investors who do not want to risk
their money in the stock market but still
want to beat inflation are good candidates. So are individuals who need
income from their investments but still
hope to preserve the value of their principal. Because of the tax implications,
holding TIPS in a tax-deferred account
seems a prudent way to use them. Pension and annuity funds are very likely to
invest in TIPS.

I

I

• Footnotes
1. Even when fully anticipated, inflation is
detrimental to investors when capital income
is taxed. The reason is that the effective tax
rate on real returns increases with the rate
of inflation.
2. See James Tobin, " An Essay on the
Principles of Debt Management," in Macroeconomics, vol. I of Essays in Economics,
Cambridge, Mass. : MJT Press, 1987, pp.
439 - 47; Milton Friedman, "Monetary Correction ," in Milton Friedman, ed., !EA Masters a/Modern Economics Series, Cambridge, Mass.: Blackwell, 1974, pp. 21- 47;
and Stanley Fischer, "Indexing and Inflation," in Journal ofMonetmy Economics,
vol. 12, no. 4 (November 1983), pp. 519- 41.
3. In 1985, the Coffee, Sugar, and Cocoa Exchange tried to trade futures contracts based
on the CPI. It turned out that there was little
interest in a market for inflation itself, and no
securities to trade it against, so the effort was
discontinued in 1991. Some speculate that
TIPS will revive interest in CPI futures. The
American public could, of course, purchase
foreign-indexed securities, but that would
expose them to exchange-rate risk, greater
default risk, and the risk that foreign inflation
may differ from U.S. price movements.
4. See Federal Registe1 vol. 61 , no. 189
;
(September 27 , 1996).
5. The CPI measure used is not seasonally
adjusted and is for all urban conswners
(CPI-U). To calculate the principal adjustment, the index is lagged three months because of the time it takes to publish it and
because of the Treasury's desire to interpolate
a day-by-day linear trend in every month. For
example, the CPI applicable to April 1 is the
reading for January, which is released to the
public in February. For.the remaining days in
April, the CPI is calculated by linear interpolation between the reading applicable to the
first day of the month (January 's CPI) and the
reading applicable to the first day of the following month (February 's CPI).
6. According to the Bureau of Public Debt,
each successful competitive bidder and each
noncompetitive bidder are awarded securities
at the price that is equivalent to the highest
accepted rate or yield.
7. Tax law suggests that a security returning
par value upon maturity is considered a debt
instrument. Since the principal amount of an
indexed security can fall below par during
deflationary periods, the Treasury may have
instituted this guarantee to prevent a challenge to TIPS ' debt-instrument status.
8. The January 1997 auction offered I 0-year
TIPS only, while the July 1997 auction
included an $8 billion issue of five-year
TIPS. Other unannounced maturities will be
issued in auctions later in 1997, as reported
in the Treasury Department's Uniform Offering Circular 31 CFR 356.

9. See Alicia H. Munnell and Joseph B.
Grolnic, "Should the U.S. Government Issue
Index Bonds?" Federal Reserve Bank of
Boston, New England Economic Review,
September/October 1986, pp. 3- 21.
10. See John Y. Campbell and Robert J.
Shiller, "A Scorecard for Indexed Government Debt," Yale University, Cowles Foundation Discussion Paper No. 1125, May 1996.
11. IfTIPS had been available over this
period, their yields would have been more
volatile than figure I suggests. As people's
tastes for consumption and saving change,
the demand for money (and thus the real rate
ofreturn) also changes. The real interest rate
affects both nominal bonds and indexed
securities in the same way. However, because
of the indexed nature ofTIPS ' payoff, their
returns would have been much less volatile
than those on nominal securities.
12. Again, this assumes a 3 percent coupon
rate, which is only an estimate. (TIPS from
the first auction provided a 3.375 percent
coupon rate.) Ignored is any shift in the real
interest rate (the opportunity cost of holding
money), which is affected by such factors as
the supply of and the demand for money. A
decrease in nominal interest rates could very
well have meant a lower TIPS coupon rate.
However, the real retmn on TIPS would not
have been negative at any point, distinguishing its performance from that of the traditional Treasury.
13. Credit risk is the uncertainty about the
government's ability or willingness to make
its coupon or principal payments. This is
assumed to be almost nonexistent for the
U.S. government. Market risk is the risk
associated with shifts in bond prices. Liquidity risk is the risk that one will not be able to
sell a security at its fair market value within a
short period after purchase. Inflation risk is
the uncertainty about investors ' returns in
real tenns.

-

Kevin H. Smgent is a senior research assistant, and Richard D. Taylor is a former
senior research assistant, at the Federal
Reserve Bank of Cleveland. This Economic
Commentary is not intended to provide
investment advice. Those who choose to
invest in TIPS do so at their own risk.
The views stated herein are those of the
authors and not necessarily those of the Federal Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve
System.

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