Tuesday, 29 November 2011

Treasury Inflation-Protected Securities - TIPS

         Treasury Inflation-Protected Securities - TIPS

      Treasury Inflation–Protected Securities are inflation–adjusted money loans to the US government. They are inflation-indexed on a daily basis since they trade daily. 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 was thus a relatively late starter in the inflation-indexed government bond market. Unlike normal nominal Treasury Bonds, these TIPS offer investors protection against inflation.

Treasury Inflation-Protected Securities, or TIPS, provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater. Treasury Direct

TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with 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 US Treasury will pay an additional amount at maturity so that the additional amount plus the deflation-indexed capital amount will equal the par amount of the security on the date of issue.
       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.
      TIPS are inflation-indexed daily in terms of a Daily CPI based on the US non-seasonally adjusted Consumer Price Index for All Urban Consumers (NSA CPI-U). The CPI-U for a particular calendar month is 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 a lagged daily interpolation of the monthly CPI. The monthly CPI is generally published several days after the close of the calendar month to which it refers. That is why the Daily CPI has to be lagged and interpolated.

A TIPS Valuation Framework, Lehman Brothers, Fixed Income Research, US Interest Rate Strategy, 2006.

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