Treasury inflation protected security refers to the type of security aimed at protecting investors in the financial market from impact of inflation. The United States government backs up this security. This form of investment has a lower risk levels compared to others. The parity value of TIPS increases with the increase in inflation level. This value is determined by the consumer price index while the rate of interest is fixed and is paid twice annually.
At maturity of the security, the treasury either pays the interest adjusted standards or the original amount whichever is higher. The bonds are usually adjusted daily despite the fact that, the accumulated amount of interest can only be reimbursed on maturity. Another attribute of this security is that, it has the allowance of adjusting to inflation. Hence, the interest earned from this can be considered as real yields rather than nominal.
In most of the treasuries, the nominal interest yields are normally a product of three sources; the real yield, an additional yield that compensates for expected inflation and an inflation risk premium” (Fabozzi 225). It is not however, to quantify the real payments for the treasury bonds owing to the undetermined inflation rate. The extra yield therefore, disbursed to the investors is a compensation of this uncertainty in inflation rates.
Tips, however, tend to provide investors with a high level of certainty by offering two yields; the first one being the real yield, and the second one the yield representing the trailing inflation which is based on the consumer price index” (Fabozzi 226). This ensures that the real rate of interest is determined beforehand, and it adjusts automatically to the increase in the inflation rate. Tips are unique owing to the clarity of their rate of return that can be predetermined. As a result, “the investors are able to determine the risk of value erosion of a bond’s principal and any future interest payments caused by an unanticipated increase in inflation” (Jarrow and Yildiray 338).
The United States government first offered TIPS in 1997. This happened to be the largest TIPS market in terms of the nominal quantity of the treasuries and its absolute market value. This was brought about by the need to protect the economy from inflation by delivering a fixed rate besides the inflation-adjusted amount. It was meant to provide a cushion for the consumer’s purchasing power that is usually affected most by inflation.
Besides this, “they provided portfolio diversification benefits owing to their low correlation with the other classes of assets” (Jarrow and Yildiray 340). Since they were introduced in the US financial market, they attracted a massive number of investors and policy makers in a unique method never been experienced before. The fact that they were free from credit risk also served as an assurance to investors in the United States.
The TIPS market has portrayed a magnificent growth since its inception. Their market value has grown from the zero percent at the time it was established to approximately 17.5% in twelve years. This is an indication of exemplary performing considering the great fluctuations experienced in the financial markets. The nominal yield of TIPS has been displaying a statistically high average value compared to the treasury’s yields.
This difference could be a result of the strategy used in TIPS administration of increasing the cost of borrowing instead of decreasing it. “The real yield of TIPS is averaged at 2.8% with a low standard deviation of 0.88%, consistent with the inflation protected nature of TIPS” (Fabozzi 213). According to the US government treasury data, the daily turnover for these securities is at 1.8% and this is lower than the other securities standing at an average of 13%.
Works cited
Fabozzi, Jafferson. Bond Markets, Analysis and Strategies, 4th ed. Upper Saddle River, NJ: Prentice Hall, 2000. Print.
Jarrow, Robert, and Yildiray Yildirim. “Pricing Treasury Inflation Protected Securities and Related Derivatives Using an HJM Model”. Journal of Financial and Quantitative Analysis 38.2 (2003): 337-358. Print.