|
|
|
rickferri
05-11-2003, 7:09 PM | Post #84405 |
| 0 |
  |
|
.
There is a lot of support for Treasury Inflation Indexed Securities on this board. But before running out and buying individual TIPS with the idea that this is the greatest investment since index funds, there is one hidden risk the needs to be mentioned which does not occur with traditional Treasury bonds. The fact is, you can permanently lose money in TIPS under certain conditions, even after inflation!
When a new TIP security is issued, the total return will be a combination of
1) interest or coupon rate
2) the growth of the maturity value or par value based on the inflation rate.
For example, the TSY INFL IX, 3 5/8%, 04/15/28 was issued at 100 par value in 1998, and is current at a par value of 113.448. So, a $100,000 original face value bond now has a face value of $113,448. The bond is paying 3 5/8% interest on a current par value, so the interest for the year on this bond will be $4,112. If the original $100,000 bond matured today, investors would get the accrued interest plus $113,448.
Between the issue date and the maturity date, the bonds can trade at a premium of discount to the current par value, depending on were other Treasuries are trading.
For example, the TSY INFL IX, 3 5/8%, 04/15/28 is trading at a price of 121.09. To find the market value you would pay on a $113,440 bond, multiply the par amount by 1.2109. The market price of bond is $137,378, which is significantly higher than the par vale of $113,448. That also means if the bond matured today, you would get only $113,448, not $137,378. This is not a bad thing, it is only the market correctly pricing the bond for today's interest rates. Based on a coupon interest payment of 3 5/8% per year over the next 25 years, your total return would still be 2.5% even after the loss of premium paid.
However, there is a hidden risk not brought out in most discussions of TIPS. In our previous example, $100,000 of original par TSY INFL IX, 3 5/8%, 04/15/28 bonds now has a par value of $113,448 and a market price of $137,378. Regardless of a fluctuation in market price, you will get at least the $113,448 plus interest at maturity as long as there is inflation or no inflation between now and 2028. However, if there is deflation (falling prices), the par value of the bonds will fall below the current par value of $113,448, How low can the par value go? All the way down to the original issue price of $100,000. If we have severe deflation, and prices fall by 13.5%, and the bond that you paid $137,378 matures at $100,000, then even after factoring in interest, your total return will be close to 0% over the next 25 years.
The Treasury department will not redeem bonds below the issue price. So the SMART thing to do is to buy TIPS on the offing price, or close to it. Do not buy seasoned TIPS, like the one above.
Just thought that needed to be pointed out.
Rick Ferri
Originally posted in thread: 27224
|
View Complete Thread
|
|
|
