Why Investors Care
Individual investors can participate in Treasury auctions either through a securities dealer (brokerage firm) or via the Treasury Direct program, which saves on brokerage commissions. But brokers commissions are often nominal (especially with discount brokers), and using a broker does eliminate a lot of paper work and other administrative hassles. Brokers facilitate the purchases and sales of Treasuries in the secondary market, which is handy for buying Treasuries at times other than scheduled auctions or for maturities other than those offered by standard new issues.
Interest rates on Treasury securities are determined in the market; the Federal Reserve does not set them. However, bond investors are sensitive to Federal Reserve policy and thus market rates will mirror policy expectations. Usually, bond market players are forward-looking and this means that interest rates on Treasury securities will move in the direction of Fed policy with a lead. As a result, one is more likely to see rising interest rates on Treasury yields during an expansion (and falling yields during economic slowdowns) in advance of policy changes by the Federal Reserve.
TIPS, inflation-indexed securities, are designed to shield investors from inflation-risk. The principal is adjusted for inflation. Instead of getting back your initial investment of $1,000, for instance, you would get $1,000 plus an additional amount tied to the inflation rate. Coupon payments will also be based on the adjusted principal amount, but since there is no inflation premium included in the nominal interest rate (coupon), interest payments (and yields attached to the TIPS) are lower than for regular Treasury securities. Economists and policymakers consider the differential between yields on 5-year TIPS and regular 5-year notes to be a proxy for investors' estimate of inflation expectations.
Primer on Treasuries
Treasury securities, Treasuries, U.S. government bonds, T-bonds, T-notes, and T-bills all refer to the same type of security: debt obligations of the United States. Maturity refers to the length of the loan to the government. TIPS, which were first offered in 1998, have had maturities of 5, 10, or 30 years. Treasury notes have maturities from 2 to 10 years (2-, 3-, 5-, 7- and 10-year notes are most common). Since 2008, the Treasury ruled that all securities it issues now have minimum denominations of $100 and must be purchased in increments of $100.
How TIPS work
The principal amount of the security is adjusted for inflation and is paid at maturity. Securities are redeemed at the greater of their inflation-adjusted principal or par amount at original issue. Interest payments, which are taxable like other Treasuries, are issued twice a year and are based on the inflation-adjusted principal at the time of payment. The index for measuring the rate of inflation is the non-seasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers published each month by the Bureau of Labor Statistics. If this index is materially changed, the Treasury will substitute an alternative index.
You pay $1,000 for a TIPS and receive interest payments every six months based on the inflation-adjusted principal on the payment date. If the coupon is 2% and the rate of inflation, for instance, stays at 0% for the entire year, you get $10 every six months for a total of $20 per year. However, since the coupon rate is applied to the adjusted principal, coupon payments will rise or fall proportionately. If the inflation rate is 10% during the year, the original $1,000 principal is adjusted to $1,100, and you get $11 in interest payments every six months for a total $22 per year. An investor can calculate the exact adjusted principal for their TIPS by multiplying the original purchased principal by the daily index ratios published on the Treasury Direct website. The index ratio for a specific security on a specific day equals the reference Consumer Price Index for that day divided by the Reference Consumer Price Index on the date of issue. If held to maturity, your $1,000 invested in TIPS is also protected against deflation, since when the TIPS matures in 5 years you get back the greater of the inflation-adjusted principal or the $1,000 par amount at original issue.
Treasuries offer a measure of security unmatched by other investments - the U.S. government guarantees the initial investment (the principal) and the interest payments. With regular Treasury securities, inflation may erode the value of both the principal and interest payments. But TIPS offer an additional level of security, protecting the investor from an onset of inflation. When TIPS are resold in the secondary market, their price could be substantially more or less than the face value. Price fluctuations in the secondary market are based on the economic environment, inflation expectations, Federal Reserve policy, and simple forces of supply and demand. Opportunity risk refers to what could have been earned had the money been invested elsewhere.
Important note: Principal growth related to inflation gain is not paid out until maturity, however, the individual is required to pay federal income taxes on this amount for the year in which it occurs. That's why many financial advisors suggest that these securities be purchased for tax-deferred retirement accounts.
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