Most Popular ArticlesMay 19, 2009
TIPS are riskier than you think
When held to maturity, TIPS yield their real interest rate adjusted for inflation. Price movements over the life of the bond, however, can be somewhat uncertain.
If real interest rates are stable, TIPS should trade near their accrued principal value. But real interest rates have been relatively unstable, and TIPS prices have fluctuated substantially. The chart below shows the market price (in red) and accrued principal value (in blue) for a 30-year TIPS issued 4/15/98 (the Treasury no longer issues 30-year TIPS; the longest maturity is now 20 years).
The market price fluctuated between 89.3 and 135, with a range of more than 30 points in 2008. Although the price is above the principal value roughly as long as it is below this value, the volatility is substantial.
TIPS have a long duration, because their cash flows grow over time, with a substantial portion due at maturity, and this is the underlying cause of the volatility. Unlike nominal bonds, the duration of TIPS is unknown, since its cash flows are contingent on future inflation rates. This uncertainty exaggerates the volatility of TIPS.
The duration of a 10-year nominal Treasury bond issued with a coupon equal to today’s yield of 3.14% is 8.92. A 10-year TIPS issued with at today’s real yield of 1.69%, assuming 3% average inflation over the next decade, would have a duration of 9.46.
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