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Treasury T.I.P.S and Stripes 101

Treasury Inflation Protection Securities (T.I.P.S.)

Treasury Inflation Protection Securities are government securities indexed to the rate of inflation. Inflation risk is eliminated because the principal value of a T.I.P.S. is adjusted semi-annually to compensate for prevailing inflation as reported by the Consumer Price Index. The T.I.P.S. then pays a coupon rate derived from the adjusted principal.

Consider the following example: A T.I.P.S has a $1,000 face value and offers a semi-annual coupon rate of 2%. Suppose inflation for the six-month period is 3%. What is the value of the coupon payment? The following formulas can be used to solve the problem:

Principal Adjustment = FV(1+r_Inflation)

Coupon Payment = Principal_Adjusted(r_Coupon)

Thus,

Principal Adjustment = $1,000 (1+0.03) = $1,030

Coupon Payment = $1,030 (.02) = $20.60

The following chart details the advantages and disadvantages of T.I.P.S:

Treasury Inflation Protection Securities

Advantages
     • Considered Free of Default Risk
     • Considered Free of Inflation Risk
     • Liquid. Little Liquidity Risk
     • Exempt from state taxes
     • Minimum face value is $1,000

Disadvantages
     • Very low yields during periods of low inflation.
     • Vulnerable to Interest Rate Risk
     • Investors must pay taxes on inflation adjustments

Zero-Coupon Stripes

Historically, retail investment firms could purchase a treasury security and separate (strip) its coupon payments and principal payment into two securities. Investors needing a steady stream of cash flows could purchase the coupon security. Investors needing a security that functioned like a zero-coupon bond could purchase the principal security. Today, the Department of Treasury issues Coupon Stripes and Principal Stripes which function in the same manner.

Questions:

1. Describe the advantages and disadvantages of T.I.P.S.

2. A T.I.P.S has a $1,000 face value and offers a semi-annual coupon rate of 3%. Suppose inflation for the six-month period is 1.5%. What is the value of the coupon payment?

a. $15.18
b. $20.45
c. $30.45
d. $70.90

3. A T.I.P.S has a $1,000 face value and offers a semi-annual coupon rate of 2%. Suppose inflation for the six-month period is 1.5%. What is the value of the adjusted principal used to derive the coupon payment?

a. $1,115
b. $1,020
c. $1,200
d. $1,015

Answers:

1. Reference

2. C

3. B