In discussing retirement liabilities, it is also important to address the issue of inflation and how to think about bonds when they are meant to fund a liability that grows with the consumer price index. Fortunately, this is now practical as the United States began issuing Treasury Inflation-Protected Securities (TIPS) in 1997. Backed by the full faith and credit of the US government and assurances that inflation cannot eat away at their value, TIPS provide a risk-free asset for US-based investors.
The face value and coupon payments for TIPS are both indexed to keep pace with inflation and preserve purchasing power, and their yields are quoted in real inflation-adjusted terms. Whenever positive inflation (as opposed to deflation) is expected, real yields will be less than the nominal yields quoted on traditional (i.e., not inflation adjusted) bonds. As an approximation:
real interest rate = nominal interest rate − expected inflation rate
Nominal interest rates are determined by compensation expected to keep pace with inflation plus a real rate of return for the investor. Supply and demand affect bond prices and interest rates. Real interest rates can be negative.
Investors may expect a positive nominal return on their investment (otherwise, there is no reason to invest), but that return may not be able to keep pace with inflation. Unlike traditional bonds, TIPS yields are quoted as real interest rates.
Their nominal yields are not known in advance because they depend on the subsequently realized inflation experience. Conversely, we know nominal yields for traditional bonds, but their real yields can only be known after observing the realized path of inflation up to the maturity date.
Inflation adjustments for TIPS are linked to the Consumer Price Index for All Urban Consumers (CPI-U). These adjustments are tracked in terms of the accrued principal, which is a unique term for TIPS. Accrued principal is the inflation-adjusted value of the initial face value since the TIPS was issued. For TIPS, inflation adjustments are realized by having the coupon rate be paid on the value of the accrued principal, not the nominal initial face value.
As well, at the maturity date, the investor receives the accrued principal back, not the nominal face value. A real coupon rate is paid on an inflation-adjusted amount, and an inflation-adjusted amount is returned at the maturity date.
If there is deflation, the accrued principal can decrease, but it is protected from falling below its initial par value. This means that TIPS on the secondary markets with lower accrued principal will be able to provide better protection from a deflationary episode, other factors being the same.
Otherwise, deflation that is not significant enough to cause the accrued principal to fall below its initial par value will hurt TIPS relative to traditional bonds. Generally, the purpose of TIPS is to provide protection from unexpectedly high inflation and buying TIPS with a lower relative accrued principal is a secondary consideration when choosing specific TIPS to purchase.
It is important to note that TIPS are purchased in nominal dollars. On the secondary market, the ask price for TIPS is quoted in real terms, represented as a percentage of the inflation-adjusted accrued principal. The price paid is the ask price times the accrued principal divided by 100.
TIPS notes and bonds have been issued since January 1997. Until mid-2002, each auction for TIPS of the various maturities provided an initial real yield above 3 percent. Lucky investors in 1998 and 1999 could have purchased thirty-year TIPS yielding close to 4 percent and yields on ten- and twenty-year TIPS exceeded 4 percent in 1999 and 2000. Since this time, TIPS yields have fallen.
An auction for a five-year note held in October 2010 made headlines as the real yield dipped below zero (to -0.55 percent) for the first time. Purchasers of those issues locked in yields that will not keep pace with inflation. Though surprising at the time, negative yields for TIPS have become the norm in recent years until the flattening of the yield curve in 2018 brought shorter-term TIPS yields above 0 percent again.
This article is part of a series; click here to read part 2.
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This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon.
