Understanding TIPS: The Compelling Case For Rising Interest Rates and How To Benefit From Them
By Bill Addiss
As we head further into 2018, the case for rising interest rates is compelling, and it Really is All About Supply and Demand!
On the demand side, those buyers of treasuries that are traditionally the largest are reducing their participation in the market, thereby reducing demand and leading to lower prices and higher yields. Specifically:
- The US Fed: After years amassing a total portfolio of $4 trillion of treasuries (mostly through ’Quantitative Easing’), the Fed announced at the end of 2017 that they will be letting these treasuries unwind. This means they will not be reinvesting in new treasuries as the ones they are holding mature.
- The Chinese Government: With holdings in excess of $1.2 trillion, China has been the second largest holder and buyer of US treasuries. However, on Jan 12, 2017, Chinese officials announced that they were curtailing purchases of US treasuries.
- Japan: The 3rd largest holder of treasuries, has steadily reduced their holdings and new purchases of treasuries as well, with the latest drop of 0.9% to $1.08 trillion being the lowest in more than 4 years (Bloomberg: Jan 2018).
- The Data: Back in 2004 - 2005, China and Japan combined accounted for more than 50% of foreign holdings and purchases of US Treasuries. As of November 2017, that amount had dropped to just 36%.
- The FOMC: They have specifically told us that they expect to raise the Federal Funds rate at lease 3 times this year (depending on economic activity).
On the supply side, the argument is just as compelling. Today, the US Deficit is at its highest level ever, requiring unprecedented treasury issuances. It is estimated that the deficit will grow by an additional $1.4 trillion in 2018, requiring new treasuries to be issued in that amount. However, it is worth noting that fiscal optimists hope that the recent Tax Bill passed in 2018 will result in stronger economic growth, thereby reducing the deficit and the amount of treasuries that need to be issued. Time will tell.
Additionally, the problem is self-perpetuating. Yes, the US government now has had to borrow unprecedented amounts of money, but we have been borrowing it at what are historically VERY low interest rates. Should rates rise, the cost of borrowing that money will also increase, requiring us to borrow even more to service our debt.
After a decade of declining or stagnant rates, it is almost certain that interest rates are going to begin rising. In fact, the yield on the 10 year treasury hit 2.80 in the first month of 2018, the highest rate in almost 4 years. The question for savers is, how to take advantage of the rise in interest rates. Most experts would agree on the following: for savers and investors looking for income, floating rate bonds like TIPS now make sense (for the first time in almost a decade!).
What Are Treasury Inflation Protection Securities (TIPS)?
Traditionally, when the government borrows money they issue a bond (or note, depending on the maturity) in $1,000 denominations, (called the par or principal value). Attached to the bond are coupons that the buyer redeems each year to collect the interest payment promised to them by the issuer (in this case the government) when they originally purchased the bond. Then at maturity, the issuer pays the investor back the par amount borrowed. Most bonds in the US are issued at a fixed rate of interest which is why we often refer to the bond market as the fixed income market.
However, there’s another type of bond that the US has introduced to investors called Treasury Inflation Protection Securities (TIPS) - a type of floating rate bond.
Floating rate bonds have not been as prevalent here in the US as in other countries. However, on those floating rate bonds that do exist, traditionally what floats, or adjusts, is the interest rate of the coupon (rather than being fixed as described above). Not so for TIPS. On these bonds, what floats is the par value of the bonds. Should inflation increase (as measured by the CPI inflation rate) the par value of the bond (originally issued at $1,000) would also increase over the life of the bond.
So for example, if you were to purchase a $1,000, 20-year U.S. TIPS with a 2.5% fixed coupon (1.25% on semiannual basis), and the inflation rate were to be 4%, the original $1,000 par on the TIPS note would be adjusted upward on a semi-annual basis to account for that 4% inflation rate. If that inflation rate were to remain steady at 4% until maturity, the principal value of the treasury will have grown to $2,208 (4% per year, compounded semiannually).
Additionally, while the coupon rate remains fixed at 2.5%, the dollar value of each semiannual interest payment will rise, as the coupon will be paid on the inflation-adjusted principal value. So, the first semiannual coupon of 1.25% paid on the inflation-adjusted principal of $1,020 would be $12.75 and the final semiannual interest payment would be 1.25% of $2,208, which is $27.60.
To recap, the investor is getting two benefits: Their return of principal at maturity has been growing (inflation adjusted), meaning their purchasing power has been maintained. Additionally, assuming there is inflation, their interest income is also increasing as the interest is now being paid semi-annually on that growing principal value.
It is important to note, that should we enter a deflationary period (negative inflation) the par value of the bonds can actually decrease. However, the government will never return the investor less than the original $1,000 issued value (referred to as a floor).
Newly issued TIPS can be purchased commission free directly from the treasury department via their website: www.treasurydirect.gov. Additionally, many mutual fund companies provide TIPS in an ETF structure which trade on exchanges.
About the Author
Mr. Addiss develops and facilitates educational programs for a variety of major financial institutions, government agencies and foreign governments.