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).
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Question on TIPS: The inflation adjustment of principal on TIPS bonds is counted as taxable income. What would happen if the inflation adjustment was negative for the year - would it count as a capital loss? Thanks
Hi Robert - You are correct, the Treasury reports TIPS principal adjustments to you and the IRS on a form called a 1099-OID.
However, the amounts reported on this form are considered to be interest, not capital gains. You add the number on this form to your other interest income. If the inflation adjustment was negative, then you'd have a reduction in income.
Tom Adams
To follow Robert's question with another…
Let's say an investor buys a TIPS bond for $1000. Let's say year 2008 ends with net deflation, and the inflation-adjusted principal is $950 by Dec 31st. As Tom said in the response above, so far this is just a reduction in income and doesn't count as a capital loss.
Now, what if in the following year, inflation brings the principal back to $1000 exactly. Must the 2009 tax return report the $50 as earned interest, even though the investor has no net gains since the original purchase?
Hey Tom,
Wouldn't these hight TIPs rates bode well for a bump up in the fixed rate for I-bonds?
Dan - That's the way I understand it. The Treasury will report a $50 loss the first year to you and the IRS and a $50 gain the following year.
JDJ - Good call! But they only bumped it up to 0.70% - 2.00% would have been fair based on how they used to set it.
Tom Adams