Pages

Wednesday, 31 August 2011

TIPS






TIPS



      Treasury Inflation–Protected Securities (TIPS) are inflation–adjusted or inflation–indexed money loans to the US government. The U.S. Treasury started issuing TIPS in January 1997. The United Kingdom has been issuing inflation-indexed bonds since 1981 and Canada since 1991. The United States of America has thus been a relatively late starter in the inflation-indexed government bond market. Unlike normal nominal Treasury Bonds, these TIPS offer investors protection against inflation as well as the opportunity to gain from deflation, but, only as far as the capital amount of the loan is concerned. Both the semi-annual coupons (interest payments) and the capital repayments of TIPS are adjusted for changes in the Consumer Price Index during inflation. Only the capital amount of the loan is maintained fixed in nominal value during deflation allowing the investor to automatically gain from the creation of real value in money during a deflationary period. This is not possible with the interest paid on the loan. The interest paid is maintained constant in real value during inflation and deflation. There is thus no automatic gain in the real value of TIPS interest during deflation.


       
       
If at maturity the inflation-indexed capital amount is less than the par amount of the security (due to deflation), the final payment of the principal will not be less than the par amount of the security at issuance. In such a circumstance, the Treasury will pay an additional amount at maturity so that the additional amount plus the inflation-indexed capital amount will equal the par amount of the security on the date of original issuance.


Nominal Treasury Bonds would gain from the fact that deflation creates real value in nominal monetary items in both the principal and in interest payments.


      The coupon paid out is the fixed rate coupon times the compounded rate of inflation from the date of issue. The capital amount repaid is the par amount or the par amount times the compounded rate of inflation from the date of the issue, whichever is greater.


      TIPS are inflation-indexed in terms of the US non-seasonally adjusted Consumer Price Index for All Urban Consumers (NSA CPI-U). The CPI-U for a particular calendar month is only published during the following calendar month. The inflation-indexed coupon and capital repayments are thus paid in terms of a TIPS Daily Consumer Price Index which is a lagged daily interpolation of the CPI-U with a two month lag. The CPI-U index value used for the calculation of the DCPI on the first day of a calendar month is the CPI-U of three months before.


       The TIPS DCPI value calculated for any given day in a calendar month is the daily interpolation of the CPI-U index value (of three months before) used at the beginning of the calendar month and the CPI-U index value (of three months before) used at the beginning of the following calendar month.


       A country which issues inflation-indexed government bonds and uses a one or two month lagged interpolated Daily Consumer Price Index to determine the daily price of these bonds can use the DCPI for the implementation of financial capital maintenance in units of constant purchasing power during inflation and deflation (CIPPA). A DCPI is not automatically a monetized daily indexed unit of account like the Unidad de Fomento in Chile. A DCPI is simply a lagged daily interpolation of the CPI.








Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.