TIPS rates jump to levels not seen for six years
Wednesday, October 29th, 2008
Categorized as: TIPS
Since early October, TIPS rates have jumped. On Oct. 3 the 5-year rate was 1.68% and the 10-year rate was 2.18%. As of yesterday, the equivalent rates were 3.79% (up 2.11 percentage points) and 3.06% (up 0.88 points).
The reason rates have jumped is that TIPS investors expect to see inflation reverse. When the CPI goes down, the principal value of TIPS declines as well. Investors are demanding a higher interest rate to cover the risk of price deflation.
Fortunately, there is a major difference between Series I Savings Bonds and TIPS in terms of how inflation is used to adjust the value of the security.
With TIPS the adjusted principal is used to calculate the amount of interest earned by the coupon rate of the security. The adjusted principal can go below par value for the purpose of calculating interest, however, when the security matures, TIPS investors get back the higher of the par value of the bond or the adjusted principal.
With I bonds the inflation/deflation rate is added to/subtracted from the fixed rate paid by the security. Since the combined rate can’t be less than zero, neither the principal value used for calculating interest nor the redemption value of the bond can go down. During deflation, I bonds are a much better investment than TIPS.
The rate on 5-year TIPS is now above the rate on 5-year Treasury Notes (2.75% yesterday).