Understanding Treasury Inflation Protection Securities (TIPS) DISCLAIMER: THE INFORMATION IN THIS DOCUMENT IS PROVIDED TO ADVENT CLIENTS AS A CONVENIENCE, AND IS FOR INFORMATIONAL PURPOSES ONLY. IT IS THE RESPONSIBILITY OF ADVENT CLIENTS TO VERIFY ALL INFORMATION CONTAINED IN THE DOCUMENT BEFORE RELYING ON IT TO MAKE DECISIONS.
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Understanding Treasury Inflation Protection Securities (TIPS) In This Document Overview..................................................... 2 What Are TIPS?................................................. 2 Why Do Investors Buy TIPS?...................................... 2 How Does the Treasury Issue TIPS?................................. 3 What Happens When TIPS Mature?................................. 3 Tracking TIPS Trades............................................ 4 How Do I Get a CPI Number for Each Settlement Date?................. 4 How Do I Calculate Market Values in TIPS Trades?..................... 6 How Do I Calculate Trade Amounts for TIPS?......................... 6 How Do I Calculate Accrued Interest in TIPS Trades?................... 6 How Do I Quote Yields for TIPS?................................... 7 Reporting on TIPS Holdings....................................... 8 How Do I Report the Cost Basis of a TIPS Position?.................... 9 How Do I Report the Quantity of a TIPS Position?..................... 9 How Do I Report the Return on a TIPS Investment?.................... 10 Where Can I Get More Information about TIPS?....................... 12
Overview In this section, you ll learn what TIPS are, why investors buy them, and how the U.S. Treasury issues them. What Are TIPS? Treasury Inflation Protection Securities (TIPS) are medium- and long-term debt obligations designed to guarantee the investor a rate of return higher than the current inflation rate. The U.S. Treasury began issuing TIPS in 1997. TIPS have many of the characteristics of standard fixed-rate Treasury notes and bonds, including: Maturities ranging from five to 30 years. Semi-annual fixed-rate coupon payments. Actual/actual interest accrual. No early expiration provisions. Return of principal at maturity. TIPS differ from standard Treasury issues by paying interest and principal in amounts that are adjusted for the Consumer Price Index for All Urban Consumers (CPI-U), published by the U.S. Department of Labor s Bureau of Labor Statistics. TIPS are eligible for stripping. This means that an eligible dealership may detach and sell TIPS interest payments and principal repayments as separate zero-coupon securities. Why Do Investors Buy TIPS? Historical rates of return on standard high-quality, medium- and long-term debt obligations are lower than rates of return on most alternatives when adjusted for inflation. This is especially true during periods of high inflation. Issuers such as the U.S. Treasury believe that prospective investors want an alternative type of debt that guarantees a real rate of return, regardless of inflation. 2 Overview
Investors can receive a return on investment in two ways. Coupon payments, and the principal received at maturity, are adjusted for inflation. Market conditions cause TIPS prices to fluctuate. How Does the Treasury Issue TIPS? 1 First, the Treasury defines the quantity and determines the original face value of an entire TIPS issue. 2 Then, the Treasury issues the TIPS at auctions in minimum denominations of $1,000, at nearpar value. The Treasury currently offers: 10-year notes, issued in January and July, paying interest and maturing on the 15th. 30-year notes, issued in April and August, paying interest and maturing on the 15th. 3 At auction, before setting the issue s coupon rate, the Treasury receives closed competitive bids, each of which specifies a yield and a quantity. The Treasury accepts bids, beginning with the lowest yield and moving to the highest yield, until the entire issue is sold. 4 The Treasury uses the average yield at auction, rounded to the nearest eighth of a percent, to determine a fixed coupon rate. This guarantees that the cost to an investor who purchases an original issue is very near the original face value. 5 On the settlement date of an auctioned issue, the Treasury assigns a base reference CPI-U number to the entire issue, representing the beginning inflation benchmark value. This base reference CPI is used in the calculation of the subsequent inflation adjustments. What Happens When TIPS Mature? The Treasury stipulates that at maturity, TIPS investors receive the greater of the following two amounts. The current face value as of maturity date, adjusted for inflation The original face value This ensures that the principal received at maturity is not reduced by deflation. Overview 3
Tracking TIPS Trades In this section, you ll learn about the values used in TIPS trades. How Do I Calculate Quantities in TIPS Trades? When TIPS trade on the secondary market, the quantities used in transactions are the original face values. The cash amounts of the transactions, however, are not based on the original face values, because the original face values do not reflect the adjustments for inflation. To calculate the cost and proceeds of TIPS as of the settlement date of a trade, you must calculate an inflation-adjusted current face value first, using the following formula. current face value = original face value * index ratio, where: index ratio = (reference CPI number as of trade settlement date) / (base reference CPI number as of issue settlement date) Note: The U.S. Treasury provides daily index ratios for each TIPS issue. CPI numbers and index ratios are also available from other information providers. How Do I Get a CPI Number for Each Settlement Date? CPI-U numbers are published only once per month, as of the first day of the month. When calculating an index value for a given settlement date, use the CPI-U number for the calendar date three months prior. (The CPI-U number for a particular month is not published until after the date it actually represents.) To derive a reference CPI number for a specific settlement date, use the published CPI-U numbers for the preceding and subsequent months to interpolate the number. Use straightline interpolation and an actual-day month. When using reference CPI numbers and index ratios in calculations, truncate after the sixth decimal place, and round to the fifth decimal place. 4 Tracking TIPS Trades
The following two examples, using the information in Table 1, illustrate the calculation of CPI numbers. Table 1: Date Published CPI value 03/01/03 184.2 04/01/03 183.8 05/01/03 183.5 06/01/03 183.7 Example 1: The CPI value for 07/01/03 Based on the published CPI value for the calendar date three months prior (04/01/03), the base or reference CPI value for 07/01/03 is 183.8 Example 2: The CPI value for 06/20/03 Based on the interpolation of the published CPI values for the preceding and subsequent months (03/01/03 and 04/01/03), the base or reference CPI value for 06/20/03 is 183.94667, calculated as follows. 183.8-184.2 = -0.4-0.4 * (days since the beginning of the month/ total days in month) = -0.25333... -0.25333 + 184.2 = 183.94666 183.94666 truncated and rounded = 183.94667 Tracking TIPS Trades 5
How Do I Calculate Market Values in TIPS Trades? TIPS trade at a premium or a discount to their current face values due to market conditions. TIPS prices are quoted as a percentage of current face value, and their market values according to the following formula. market value = (current face value) * price * 0.01 How Do I Calculate Trade Amounts for TIPS? Calculate trade amounts, such as cost and proceeds, according the following formula. trade amount = (current face value) * (trade price) * 0.01 How Do I Calculate Accrued Interest in TIPS Trades? On the secondary market, when TIPS trade between coupon dates, the seller pays the buyer accrued interest as of settlement date. Calculate accrued interest as of settlement date according to the following formula. accrued interest = (current face value) * ( annual coupon rate / 2) * (actual days elapsed / actual days in coupon period) 6 Tracking TIPS Trades
The information in the following table illustrates the values associated with a TIPS trade. Issue date 01/15/03 Base reference CPI 181.3 Coupon rate 4% Maturity date 01/15/13 Original face value 10,000 Settlement date of trade 06/20/03 Settlement date reference CPI 183.94667 Quantity of trade 10,000 Trading price 102 Index ratio 1.0146 Current face value 10,146 Trade amount $10,348.92 Accrued interest $174.89 Total proceeds of trade $10,532.81 How Do I Quote Yields for TIPS? The U.S. Treasury has established conventions for calculating TIPS yields based on the unrealistic assumption that no inflation will occur, and projecting all cash flows used in the calculation according to that assumption. This convention: Understates the expected nominal yield, which does not reflect adjustments for inflation. Provides for a unique real yield, which reflects adjustments for inflation. Tracking TIPS Trades 7
Because TIPS yields are quoted in real terms, comparisons with the nominal yields of standard issues are meaningless, unless adjusted as illustrated in the following example. Treasury bond yield 4% TIPS yield 2% Implied inflation expectation 1.96% (1.04 / 1.02) Investor A expects 3% inflation spread evenly over the life of the bonds more than the implied inflation expectation of 1.96%. The TIPS offers an expected nominal yield of 5.06% (2% real yield * 3% inflation) higher than the 4% nominal yield of the Treasury bond. Investor A buys the TIPS. Investor B expects 1% inflation spread evenly over the life of the bonds less than the implied inflation expectation of 1.96%. The Treasury bond offers a nominal yield of 4% higher than the expected nominal yield of 3.02% (2% real yield * 1% inflation) of the TIPS. Investor B buys the Treasury bond. Reporting on TIPS Holdings While the U.S. Treasury and the brokerage community involved in the marketing of TIPS establish the conventions for sell-side quotation and trading of TIPS, and the Internal Revenue Service (IRS) establishes the terms and conditions for tax treatment, no recognized regulatory body has established conventions for buy-side accounting and valuation of TIPS. To report the market value and accrued income of TIPS, follow the guidelines described in How Do I Calculate Market Values in TIPS Trades? on page 6 and How Do I Calculate Accrued Interest in TIPS Trades? on page 6. In this section, you ll learn about additional considerations required when reporting the cost basis, quantity, and investment return of TIPS. 8 Reporting on TIPS Holdings
How Do I Report the Cost Basis of a TIPS Position? You can report the cost of TIPS by using the following two adjustments to the original cost. inflation-adjusted cost = original cost * (reference CPI as of report date) / (reference CPI as of opening settlement date) inflation-adjusted cost after accretion or amortization = (inflation-adjusted cost) +/- (accretion or amortization as of report date) Note: The total amount of cost accreted or amortized between the opening settlement date and the maturity date is equal to the difference between the original cost and the current face value as of the opening settlement date. Subsequent adjustments for inflation have no effect on the accretion and amortization amounts. Scientific amortization is based on real yield to maturity on cost, which assumes zero inflation. How Do I Report the Quantity of a TIPS Position? You can report three different types of TIPS quantities. Original face value identifies the opening and closing of each tax lot, and is used to calculate current face values as of trade date, income payment, and report dates. Current face value as of opening settlement date is used to calculate accretion or amortization from the opening settlement date to the maturity date. Current face value as of report date is used to calculate market value as of report date. Reporting on TIPS Holdings 9
How Do I Report the Return on a TIPS Investment? You can report the return on a TIPS investment (income and realized gain or loss) according to the following guidelines. Income IRS rulings stipulate that investment return attributable to adjustments for inflation are reported as income. The IRS requires the following two adjustments to income for each tax period. Change in cost due to inflation adjustments Accretion or amortization of cost (as of opening settlement date) to current face value You can make these two adjustments at the same time by attributing to income the change in current inflation-adjusted cost after accretion or amortization. Use the following formula. income adjustment = (ending inflation-adjusted cost after accretion or amortization) - (beginning inflation-adjusted cost after accretion or amortization) Realized Gains and Losses The IRS requires you to report cost basis as inflation-adjusted cost after accretion or amortization. Use the following formula. Realized gain or loss = (proceeds) - (inflation-adjusted cost after accretion or amortization) Adjusting cost in this way associates the effects of inflation and accretion or amortization with income rather than with gains and losses. 10 Reporting on TIPS Holdings
Original Issue Discounts (OIDs) The IRS defines OID as a discount from an original issue price. The original issue date, price, and yield must be used to calculate the OID for any period using the constant yield method. For an investor who purchases TIPS in the secondary market at a yield lower than the original yield, this method of OID accrual overstates the amount of imputed OID interest that the investor actually accrues, and therefore overstates the investor s tax liability. For an investor who purchases TIPS in the secondary market at a yield higher than the original yield, this method of OID accrual understates the amount of imputed OID interest that the holder actually accrues, and therefore understates the investor s tax liability. The IRS allows for the following adjustments, equal to the difference between the OID from original issue price and the OID from purchase price, used when calculating the total imputed OID income for any period. In the case of an premium on original issue yield: imputed OID income on purchase price = (imputed OID income on original issue price) - (imputed OID income premium) In the case of a discount on original issue yield: imputed OID income on purchase price = (imputed OID income on original issue price) + (imputed OID income discount) In either case, the OID income that you report each period to the IRS is equal to the imputed OID income based on purchase price. Note: This figure is also equivalent to the period s accretion (positive imputed income) or amortization (negative imputed income) of the difference between par value and purchase cost, calculated using the standard scientific method. Reporting on TIPS Holdings 11
Where Can I Get More Information about TIPS? For additional information on TIPS, visit the Department of Public Debt s Web site (http:// www.publicdebt.treas.gov/of/ofinflin.htm). You may also call the Treasury s Office of Financing at (202) 691-3550. Whom Can I Contact about This Document? To forward comments or ask questions about this document, send an e-mail to white_papers@advent.com. An Advent employee will respond to you, generally within one business day. To discuss this topic with others in the Advent community, visit the Client Talk area on Advent Connection (http://connection.advent.com). 12 Where Can I Get More Information about TIPS?