Question

SOME TIPS ON TIPS
Bondholders look at inflation like Superman looks at kryptonite. Superman weakens when faced with the dreaded substance and would die if exposed to it for long. Bondholders weaken when inflation heats up because it causes bond prices to buckle and fixed payments to lose their purchasing power. Some people have the mistaken impression that they can't lose money investing in Treasury bonds. But they can because bond prices fall in an inflationary environment. So that investors can buy its bonds without fearing inflation, in 1997 Uncle Sam created TIPS, Treasury inflation-protected securities.
Here's how TIPS work: The government issues a 10-year bond with a $1,000 face value that pays, say, 3% interest—and that rate stays fixed for the life of the issue. But if the consumer price index rises, so does the face amount of the bond. For example, because the CPI rose 2.4% in 2002, the new face amount was adjusted up to $1,000 x 1.024 - $1,024. Therefore, in 2003, the annual interest payment was $30.72 (3% of $1,024). When the TIPS mature in 10 years, the investor gets the inflation-adjusted face value at that time, which could be as much as $2,000 if inflation really takes off. A lot can change over a decade, but inflation looks pretty tame these days. As one professional investor puts it, buying TIPS now is like buying flood insurance during a drought. TIPS also protect you if deflation occurs. The bond's value will not fall below its initial face value (of $1,000).
Unlike the case with conventional fixedincome securities, the investor doesn't have to worry about the Treasury bond's value plummeting if inflation heats up. Take a look at what happens to a conventional Treasury bond if inflation begins to rise sharply. If the bond's coupon is, say, 5%, investors get 5% per year, or $50, no matter what happens to the level of prices. In 10 years, that $1,000 principal will certainly have less purchasing power than it does today. It might be able to buy just $700 worth of goods. In addition, rising inflation generally means rising interest rates. In the marketplace, conventional bond prices fall when interest rates rise. Therefore, an investor who wishes to sell a conventional bond prior to maturity is likely to take a loss if interest rates are higher than when the bond was purchased.
TIPS protect investors from such erosion in bond prices. TIPS are not so great, however, if inflation stays dormant, because the investors are getting only 3% on their money. (In fact, the coupon for the July 2003 10 year TIPS was just 170/0, compared to 4.25% for a regular 10 year Treasury note issued in August 2003.)
There's one other downside to TIPS: taxes. Investors have to pay a tax on the increasing face value of their bonds—$34 in the first year in the foregoing example. That may not seem like much, but the government doesn't actually pay out the increase in the bond's face value until maturity. Thus you end up paying taxes on income you've earned but don't have in hand. For that reason, TIPS probably make the most sense for individual retirement accounts (IRAs) and other tax-deferred retirement accounts. You can buy TIPS directly from the U.S. Treasury using Treasury Direct or from a broker. Several mutual fund companies now offer funds that buy only TIPS.
TIPS are also a good idea for investors who want to allocate a portion of their assets to income-generating securities and don't want to worry that inflation will erode their value. But the tradeoff for that protection is significant: loss of about half the income.

Please answer the question.

CRITICAL THINKING QUESTIONS Why would investors be interested in TIPS? Why would the U.S. Treasury issue such a security? What are the advantages and disadvantages of this security from the investor's point of view?

Answer 1

1. Benefits of TIPS for investors -

Investing in fixed income bearing securities is not always beneficial as the intermediate and terminal cash flows are pre determined irrespective of the Required rate of interest of the investor. The required rate of interest is nothing but the discounting rate used by the investor to value the security. It includes Risk free factor as well as the risky factor.

As the Required rate of interest increases, the Bond prices decrease or you can say that investor starts expecting more intermediate or terminal cash flows.

Example -

Year	Cash flow	DF @ 10%	Discounted CF
1-5	15	3.7908	56.86
5	100	0.6209	62.09
Total			118.95

Year	Cash flow	DF @ 15%	Discounted CF
1-5	15	3.3522	50.28
5	100	0.4972	49.72
Total			100.00

As the Rate of interest rises from 10% to 15% the Bond prices decrease from 118.95 to 100. You can see that bond prices and Rate of Interest are inversely proportional to each other.

There is a concept called inflation adjusted discount rate which adjusts the Rate of return with respect to inflation and deflation.

To compensate this, TIPS offers incremental cash flows in proportion to inflation rate so that the Bond prices remain constant irrespective of the Discounting rates.

By using TIPS, investors can be sure of earning pre determined income from securities irrespective of the rise in inflation. So when in a portfolio, investor includes risk free bonds in a definite proportion, he can balance the risk of the portfolio in an effective manner by being sure of the income and risk involved.

2. US Government would prefer to issue such bonds just to provide risk free income to the investors who wish to invest their savings and expect to earn enough for their survival. TIPS would eliminate the chances of losses to the investors.

3. Advantages -

Elimination of the inflation fluctuation from investment.

Balancing of portfolio risk and returns.

Providing steady return on investment.

Preservation of steady purchasing power in the long run

4. Disadvantages -

Comparatively higher costs for TIPS than normal Bonds.

Factors other than inflation still effect bond prices.

Lesser rate of return as effectively no default risk exists.