Strategic. Independent. Relational. Transparent. TREASURY INFLATION PROTECTED SECURITIES JUNE 2017 Part I: An Introduction to TIPS 1 Executive Summary Treasury-Inflation-Protected Securities (TIPS) allow investors to lock in a real yield by providing a return hedged against both default and inflation. As such, TIPS can be an effective tool for investors who are looking for: An income stream that adjusts to unexpected increases in living expenses, or A conservative portfolio diversification tool with relatively low correlation to stocks and bonds. TIPS aren t risk-free, however. Like all bonds, TIPS will fall in value if real interest rates increase. Consequently, TIPS perform best when real rates are falling and inflation expectations are rising. Taxable investors should also be aware that TIPS generate phantom income that is taxed at ordinary rates. In 1913, the year Richard Nixon was born, a loaf of bread cost a nickel. By the time he became president in 1969, bread peddlers were demanding five times that much for the same loaf. After Nixon ended the link between the dollar and gold in 1971, inflation soared, doubling the price of bread and other living expenses over the ensuing decade. During that inflationary decade, risk-free US 10 Year Treasuries earned negative real returns, eroding fixed income investors purchasing power by as much as 20%. As a result, bond holders dependent on a fixed income stream endured a steady decline in their standard of living. It wouldn t be until the arrival of TIPS nearly two decades later that investors would have a tool for such a macroeconomic environment. FIGURE 1. The Purchasing Power of a Dollar 1 $1.00 $0.75 $0.50 $0.25 1913 1940 1965 1990 2017 Source: U.S. Bureau of Labor Statistics
TIPS Hit the Market One consequence of the price shocks of the 1970s and early 1980s was a surge in investor demand for assets that could hedge inflation risk. In 1981, the United Kingdom Treasury was first to respond to this appeal, issuing Index-Linked Gilts that were tied to inflation. A decade and a half later (1997), The US Treasury followed suit introducing their own government backed, inflation-linked bonds, which they dubbed Treasury Inflation Protected Securities. TIPS now account for roughly 10% of outstanding Treasuries. 2 FIGURE 2. Total TIPS Outstanding 2 $ Trillions % of Total 1.4 1.2 1.0 0.8 0.6 0.4 0.2 TIPS Percentage of Total Treasuries Total TIPS Outstanding 0.0 0% 1995 1998 2001 2004 2007 2010 2013 2016 12% 10% 8% 6% 4% 2% The Mechanics of TIPS 2 Like traditional Treasuries, TIPS have a fixed coupon rate. Unlike traditional Treasuries, however, the principal value of a TIPS bond (i.e., the amount to be paid back at maturity and upon which coupon payments are based) is adjusted each month according to changes in the Bureau of Labor Statistics CPI-U index. As a result, even though the coupon rate is fixed, the semi-annual payments differ each period based on the bond s current principal value. It is important to note that in a period of deflation (i.e., falling prices for items in the CPI basket) the inflation adjustment can actually reduce the TIPS principal value and the corresponding coupon payments. At maturity, however, holders receive the greater of the inflation-adjusted principal amount or the face value of the bond, ensuring that investors will at least receive the face value of the bond back during periods of deflation. The CPI-U, or Consumer Price Index for All Urban Consumers, tracks monthly price changes for a representative basket of goods and services. The largest components of the CPI-U are Housing (43%), Food (15%), and Transportation (15%). 3
TIPS Cash Flows Based on an example from the Philadelphia Fed, Table 1 compares the cash flows of nominal and inflation-linked Treasuries. The example assumes a TIPS coupon rate of 3%, and actual and expected inflation of 2% over the entire 10-year period. To make the returns comparable, the coupon rate on the nominal bond is set at 5.06%. Although the nominal value of the traditional Treasury is unchanged throughout the period, Table 1 shows how inflation erodes the purchasing power of the principal. Ultimately, at maturity, it could only purchase $820.35 of goods in today s dollars. The example also shows how the purchasing power of the fixed nominal payment of $50.60 falls each year. Contrast that with the TIPS bond, which doesn t lose any purchasing power over the entire investment period. Both the income and the principal value are adjusted for the actual inflation rate of 2%, preserving the TIPS real return of 3% per annum. TABLE 1. Cash Flow Illustration: TIPS vs. a Traditional Treasury Bond 4 10 Year Treasury Bond 10 Year TIPS Bond Year Value of Principal of Principal Interest of Interest Year Value of Principal of Principal Interest of Interest 1 1000.00 980.39 50.60 49.61 1 1020.00 1000.00 30.60 30.00 2 1000.00 961.17 50.60 48.64 2 1040.40 1000.00 31.21 30.00 3 1000.00 942.32 50.60 47.68 3 1061.21 1000.00 31.84 30.00 4 1000.00 923.85 50.60 46.75 4 1082.43 1000.00 32.47 30.00 5 1000.00 905.73 50.60 45.83 5 1104.08 1000.00 33.12 30.00 6 1000.00 887.97 50.60 44.93 6 1126.16 1000.00 33.78 30.00 7 1000.00 870.56 50.60 44.05 7 1148.69 1000.00 34.46 30.00 8 1000.00 853.49 50.60 43.19 8 1171.66 1000.00 35.15 30.00 9 1000.00 836.76 50.60 42.34 9 1195.09 1000.00 35.85 30.00 10 1000.00 820.35 50.60 41.51 10 1218.99 1000.00 36.57 30.00 For the sake of simplicity, the example uses annual, rather than semi-annual coupon payments. In practice, a Treasury bond that has a 5% coupon rate makes semi-annual payments of 2.5%, which compounds to 5.06% per year. How the TIPS Coupon is Calculated Step 1: Find the CPI Index Rate for your specific TIPS [published by TreasuryDirect] Step 2: Calculate the Inflation Adjusted Principal Value [Original Principal Value x CPI Index Rate] Step 3: Calculate the Semi-Annual Coupon [Coupon Rate 2 x Adjusted Principal] 3
TIPS Taxation As a result of the structural differences in cash flow between TIPS and nominal Treasuries, the tax treatment of these two government securities differs. Investors are wise to be aware of these differences because they have an impact on after-tax cash flows, though not necessarily after-tax returns. 5 TIPS Are Taxed Differently Than Traditional Treasuries Investors in traditional US Treasuries pay income tax on the periodic coupon payments, and capital gains tax on any profit at the time of sale. If held to maturity, traditional treasury holders don t pay any tax on the return of principal. For TIPS investors, however, both the semi-annual coupon payment and the inflation adjustment to principal are treated as taxable income in the year they occur. In other words, although TIPS holders don t actually receive the inflated principal value until maturity, they have to pay Federal income tax on the adjustments annually. Investors in this situation are said to receive phantom income for which they must pay actual tax. Furthermore, in scenarios when the inflation adjustments are significant, holders of individual TIPS can end up in a negative cash flow situation (i.e., they are paying out more in taxes than they receive in interest payments). This negative cash flow situation isn t rectified until the inflation adjusted principal value is received at maturity. 4 Unique, But Not Necessarily Tax-Disadvantaged Given the phantom income and the potential for negative cash flow, some researchers and market participants have referred to TIPS as tax-disadvantaged investments. At first blush, this seems a logical conclusion, since all else equal, investors would prefer to avoid the potential for periods of negative cash flow. Researchers who have studied the issue, however, have found that market participants take these inconveniences into account, adding a tax-disadvantage premium into the market price of TIPS. These studies also show that this tax disadvantage premium mitigates the likelihood of a TIPS investor receiving a negative cash flow because the tax paid on the phantom income of inflation accruals is generally small. 6 Investors who are particularly concerned about the potential for negative cash flow may avoid the issue by investing in TIPS mutual funds and ETFs, as those vehicles are required to include the inflation adjustments to principal as a part of regular income distributions. 7 In sum, although there are clearly inconveniences related to the taxation of TIPS, a strong case can be made that investors are compensated for the hassle. Although TIPS holders don t actually receive cash flow from inflation adjustments to principal until maturity, they have to pay income tax on the adjustments annually. Investors in this situation are said to receive phantom income for which they must pay actual taxes.
Fixed Income Risk Factors Kings Path takes an evidence-based, risk factor approach to understanding investment returns. In this paradigm, investors earn returns by exposing their capital to different types of risk. An advantage of this approach is that it provides a framework in which risk exposures (referred to as risk factors, or risk premia ) can be added together like building blocks to create a variety of return streams. The The fundamental building block of all return streams is the real risk-free rate, which compensates an investor for allowing someone else to use their money, even if the investor is certain that all the money will be returned with the same level of purchasing power. Since this lost opportunity premium is common across investment opportunities, the real risk-free rate is considered a baseline return requirement for all investment evaluations. Adding Risk Premia to the Investors can enhance expected returns by adding additional risk premia on top of the real rate. In the case of fixed income, investors earn the majority of returns by taking risks on the quality of the borrower, the level of future inflation, and how long they lock-in the interest rate. These factors are outlined in Figure 3. FIGURE 3. Fixed Income Investors Can Take Three Core Risks Credit Risk Premium Is the borrower going to repay all of my money on time? Inflation Risk Premium Will the income from this bond be able to buy as much stuff in the future? Duration Risk Premium If I lock-in this rate now will I miss out on higher rates in the future? The risk-factor approach is based on the idea that investors earn returns by exposing their capital to different types of risk. 5
The Building Blocks of TIPS Returns TIPS are a unique breed of fixed income. As Figures 4 & 5 make clear, the primary drivers of TIPS returns are compensation for actual inflation and exposure to the duration risk premium. TIPS do not expose investors to credit risk. Like all US Treasuries, TIPS are US government guaranteed, making them essentially free from the risk of default. TIPS also eliminate inflation risk by delivering cash flows that are adjusted for actual, historical inflation. By contrast, all nominal bonds, including traditional Treasuries, will lose value if actual inflation turns out to be higher than expectations. But this does not mean that TIPS are a riskless investment. To the contrary, despite essentially eliminating credit and inflation risk, TIPS have been more volatile than traditional Treasury portfolios of similar maturity. 8 This is primarily because the inflation adjustments to principal are not paid out until maturity. As a result, TIPS have greater duration risk than Treasuries of equal maturity. 9 Consequently, TIPS can be very sensitive to changes in the real interest rate. FIGURE 4. Which Factors Drive TIPS Returns? Credit Risk Unexpected Inflation Risk Actual Inflation Duration Risk Illiquidity Premium Tax-Disadvantage Premium No No TIPS Exposure to Non-Core Risk Factors Historically, TIPS have also offered an illiquidity premium compared to nominal Treasuries (i.e., investors have been compensated for the TIPS markets being less liquid). Estimates of this premium range from 10 40 basis points in normal times, with spikes well above this range when investors flock to traditional Treasuries for safety (e.g., 2008 financial crisis). 10,11 There is also evidence that TIPS investors earn a tax-disadvantage premium, which is explained in the TIPS Taxation section of this report. FIGURE 5. Components of Return: TIPS vs. Other Fixed Income Securities Tax-Disadvantage Premium TIPS Illiquidity Premium Actual Inflation Duration Risk Premium TIPS look back and compensate investors for actual, historical inflation. bonds look forward and estimate inflation plus the risk it will increase. Inflation Risk Premium Expected Inflation Duration Risk Premium Credit Premium Anticipated Credit Default Losses Inflation Risk Premium Expected Inflation Duration Risk Premium 6 10 Year TIPS 30-Day T-bill 10 Year Treasury BBB Corporate Bond
Conclusion As the only available investment that offers a government guaranteed, inflation protected real return, TIPS are an interesting investment option. To achieve this direct relationship with inflation, TIPS cash flows are structured differently than traditional Treasuries, resulting in different tax treatment. TIPS holders should also be aware of the potential for periods of negative cash flow. That noted, there does not appear to be a material difference in after-tax returns between TIPS and traditional Treasuries. Because TIPS essentially eliminate credit and inflation risk, the majority of returns are derived from actual inflation adjustments and exposure to the duration risk premium. The illiquidity and tax-disadvantage risk premia also contribute to TIPS returns, though there is no definitive view on the long-term size of these premia. Investors intrigued by the unique characteristics of TIPS can learn more in the second paper of our TIPS research series, The Role of TIPS Portfolio Construction. References 1. United States Bureau of Labor Statistics (inflation data); Federal Reserve Bank of St. Louis (Treasury returns). 2. Monthly Statement of the Public Debt of the United States (April 30, 2017). 3. United States Bureau of Labor Statistics (December 2016). 4. Wrase, J.M. (1997). Inflation-Indexed Bonds: How Do They Work? Federal Reserve Bank of Philadelphia, 5. Frost, M. A. (2013). An Empirical Analysis of the Liquidity and Tax Disadvantage of TIPS and Their Effect on Treasury Borrowing Costs. EDITORIAL OBJECTIVE, 1001, 11. 6. Ibid. 7. I.R.C. 4982 (amended 2010). 8. Based on Kings Path comparison of trailing 5 year standard deviation for GOVT and TIP ETFs (June 8, 2017). 9. Barnes, Michelle L. et al. "A TIPS Scorecard: Are They Accomplishing Their Objectives?". Financial Analysts Journal 66.5 (2010): 68-84. Web. 10. Haubrich, J. G., Pennacchi, G. G., & Ritchken, P. H. (n.d.). Inflation Expectations, Real Rates, and Risk Premia: Evidence from Inflation Swaps. 11. Grishchenko, O. V., & Jing-Zhi, H. (2013). The Inflation Risk Premium: Evidence from the TIPS Market. Journal Of Fixed Income, 22(4), 5-30. 7