TIPS - Treasury Inflation Protection Bonds - how to figure out if a TIP is a good deal?
As we have heard time and time again from innumerable postings, I-Bonds are a great deal. But one is allowed only to buy $10,000 in a year (and an extra $5,000 if one applies their refund to buying them).
But since I've maxed out on my I-bond allotment, I've been looking at TIPs. I've always thought they sucked, e.g. whenever I see TIPs bond fund or ETF total returns (not just recently but pre-pandemic as well), they are pretty poor (this year they are negative for intermediate and long-term ones, because rising interest rates makes old bonds worth less).
So I will buy an individual bond and hold it until maturity.
First, I don't know how to buy a new one -- I have to wait for an auction date, and those are too far out in the future and I want to get my cash fund (a money market fund earning about 2.5%) invested ASAP in something higher.
Also, I want this for my Roth IRA for several reasons. I don't think I can have a Roth IRA at TreasuryDirect.
So I looked in the secondary market.
This Schwab article gives a very good explanation of the fundaments or TIPS.
https://www.schwab.com/learn/story/treasury-inflation-protected-securities-faqs-about-tips
But it doesn't explain how to know whether a particular deal available on the secondary market looks good.
I've done some mock purchase scenarios at Fidelity and Vanguard (where I do everything except click the final submit button), and I'm being asked to spend $19,975 for $10,000 face value of bonds on Friday 11/4/22 for this animal (of course these prices aren't good anymore, but for a snapshot in time):
CUSIP: 912810FD5 < - yes, it can be Googled
UNITED STATES TREAS BDS 3.62500% 04/15/2028 - it’s a 30 year TIPS bond
It was issued 4/15/98 (yes, last millennium) and matures 4/15/28 (5.4 years from now)
I don't know what happened in the early years in the bond's life, but for illustration, let's pretend inflation was 4% in the early years. Then the situation in the first 2 years looks like the first 5 lines of the table below.
Then after the ellipses (...) , the 10/15/22 and 11/4/22 information is from their data. The adjusted principal is the index ratio * 10,000.
https://www.treasurydirect.gov/auctions/announcements-data-results/tips-cpi-data/
And what follows the ellipses is my spreadsheet projection of what the adjusted principal and interest payments would be if inflation continued at 4% for the remaining life of the bond.
The principal, which begins at $10,000, is adjusted upwards every 6 months according to the CPI-U. That's why it's called Adjusted Principal.
The final Adjusted Principal value, at the 4/15/28 maturity date, $22,724.41 is the amount one gets from the Treasury for it (remembering that the above table is assuming that inflation from here on is 4%). Plus one receives the final interest payment of $411.88.
One can't "cash out" earlier than the final maturity date. But one can sell it on the secondary market. What it will sell for should be close to the adjusted principal on that date. But the market is the market, and there is no guarantee what one will get for it on the secondary market.
The semi-annual interest payment is:
coupon rate / 2 * adjusted principal
I've shown a couple examples in the above table.
So the question is, is $19,975 plus accrued interest a good price to pay for the stream of interest payments shown 4/15/23 and after, plus getting $22,724.41 at final maturity?
There ought to be something "out there" on at least one of the interwebs that would answer that question:
Enter the CUSIP of the security: __912810FD5__
Enter the assumed inflation rate from here onward to maturity: __4.0%__
Answer: your calculated rate of return is 5.9% (or whatever)
Anyway, 5.9% was what I got in my first approximation of this from the spreadsheet. So yes, it’s a good deal because one canNOT find a regular Treasury note with a 5.9% rate that matures in 5.4 years or 5 years or 6 years.
However, if I assumed inflation going forward averaged 2%, my rate of return would be about 3.9%. That is less than the 4+% interest rate that 5 year and 10 year regular treasuries offer now. So if I believed inflation over the next 5.4 years will average 2% or less, I would get a regular treasury note instead of a TIP.
But there doesn't appear to be any such calculator or anything that makes it simpler than the egghead-with-a-spreadsheet approach.
One shouldn't have to construct a spreadsheet. And then because a purchase, like on 11/4/22 for example, falls in-between interest payment dates, one has to fool around with adjusting for my spreadsheet to handle that somehow. I can think of reasonable ways to do that, but it is a little messy.
I used Excel's IRR function (internal rate of return) to get an approximation, but that function requires that the transactions be equally spaced apart. So I have more work to do.
But darn it, I'm sure I'm not the only one that has this question when examining a prospective TIP.
Then the accrued interest thing - the concept is simple: The previous owner owned the bond for the 20 days since the 10/15/22 interest payment (20 days between 10/15/22 and 11/4/22), but I, the new owner, gets the next interest payment, due 4/15/23, in its entirety and the previous owner gets nothing.
So the accrued interest thing is something I pay for 20 days of interest to compensate the previous owner.
SOME SMALL DETAILS
I'm buying much more than $10,000, but I'm showing the above table in units of $10,000. A bond is actually $1,000 face value but one must buy a minimum of say 60 of those for a minimum purchase of $60,000.
Probably will add some more in this section, but can't think of anything to add right now.
From Schwab, 10/20/22:
https://www.schwab.com/learn/story/treasury-inflation-protected-securities-faqs-about-tips
How can I compare TIPS to traditional Treasuries
Breakeven inflation rates. The breakeven rate is the difference between the yield of a nominal Treasury and the yield of a TIPS with a similar maturity. For TIPS investors, the breakeven rate can be considered a hurdle rate—it's what inflation would need to average over the life of the TIPS for it to outperform the nominal Treasury.
Breakeven rates are well off their recent highs. At 2.5%, the five-year TIPS breakeven rate is well off its recent high of 3.7% hit the past March. If the CPI were to average more than 2.5% over the next five years, the five-year TIPS would outperform a five-year nominal Treasury. (Likewise, if inflation averaged less than 2.5%, the nominal Treasury would outperform.) TIPS breakeven rates are relatively low given the high current rate of inflation ((meaning that TIPS are a good deal relative to regular treasuries at this point in time -Progree))
The above is all very fine and wonderful and all that, and it gives me a warm and fuzzy feeling, but it doesn't tell me what the rate of return is of a particular TIP on the secondary market.
Thanks for any ideas
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