Buying Inflation Protected Treasuries

The TIP ETF And SellDirect For Treasury Inflation Protected Securities

You have three basic choices if you want to buy inflation protected securities backed by the printing press of the U.S. Treasury. The first option is to go to TreasuryDirect.gov and purchase TIPs (Treasury Inflation Protected Securities) in their native 5, 10 or 30 year maturity. The minimum purchase is $1,000 and the maximum is $5,000,000. Like I-Bonds, they are sold with a fixed interest rate for starters, but unlike I-Bonds, the interest is paid every six months, rather than compounding. And where the interest rate on I-Bonds is adjusted every six months in accordance with inflation as measured by the CPI-U, with TIPs, the principal is adjusted every six months according to the CPI-U. Note that the principal adjustment is taxable as income in the year that it is made. The net effect is that while inflation grows, your principal grows to keep up with it and you receive larger interest payments as well, since they are made on a larger principal. Of course, if there's deflation, the principal shrinks and your interest payments go down, but the Treasury guarantees to pay at least the face value of the security on maturity, so you can't lose principal in an extended deflationary period. TIPS were modeled on the Real Returns Bonds offered by the Government of Canada. Treasury Securities are sold at a discount.

When I purchased some 10 year TIPs a couple years ago, the discount was just under 2.5%, meaning the government was selling every $100 of face value for just over $97.50. The interest rate above inflation for that auction was 1.375% on the ten year. I bought some TIPs in the five year auction as well, the purchase price was $99.76 (a 0.24% discount) and the interest rate was 0.5%. I thought I was getting a lousy deal, but today it's much, much, worse. The 10 year TIPS in the auction two weeks ago, November 2011, yielded 0.1%, just one tenth of a percent. The sole reason people are buying them is for the inflation protection, but given the fact you have to pay taxes on the principal adjustments, purchasing TIPs at such a low yield locks in post-inflation loss. You are accepting a steady erosion of purchasing power for ten years.

Think that's bad? The previous auction of 5 year TIPs in August 2011 yielded -0.825, a negative eight tenths of a percent. So for five years, you've locked in losing almost 1% of your principal, with the added privilege of paying income tax on positive principal adjustments. People paid nearly $107 for $100 worth of face value for that 5 year tip, it's just wacky. And the last 30 year TIP auction yielded 1%, which meant you paid $133 per $100 of face value up front, and if you hold the security for thirty years and the government starts reporting inflation honestly, you might just break even in terms of purchasing power. Depends on your tax situation.

The second choice is to buy into a managed fund of inflation protected treasuries. For that, you can read the prospectus of the company offering the fund, keeping in mind that your principal in mutual funds is not protected, but will vary with the current interest rate environment and the willingness of investors to buy shares. The third option is the TIP ETF, a Lehman iShares product. It should exhibit the same behavior as a fund of treasury inflation protected securities, but is tradable throughout the day like a regular stock. A quick look at the performance of the TIP ETF over the period of it's life (late 2003 through the present) shows that it can move up or down 10% pretty rapidly with changes in the Federal funds rate and the economic outlook. It can move 1% or more in a single day, which doesn't make it sound like the safe investment you'd think. Buying shares of anything is always speculation, if you have a chunk of money you want to squirrel away and protect from inflation, the only way to do it is to buy the securities direct from the treasury.

But what if you don't want to hold onto the inflation protected security for 5 or more years, or if an emergency comes up? It turns out that you can sell the securities prior to maturity through SellDirect, the trading service built-into TreasuryDirect. There is a mandatory 45 day holding period before you can sell them, and if you try selling during the Closed Book Period, the treasury will just cancel the sale and put the securities back in your account. The Closed Book Period starts four days before a scheduled interest payment, or the maturity of the security, but you'd have to be in a hell of a rush to sell on the open market to save four days. The treasury uses the mysterious language "transactions may be processed" after the holding period is up. May be processed?

When you request to sell a 5, 10 or 20 year treasury inflation protected security through SellDirect, TreasuryDirect passes the order to the Chicago Fed, which processes the sale and charges you $45.00 per security. That's a hefty 4.5% on a $1,000 security, so it makes sense to avoid buying a lot of small face value securities in favor of buying larger notes. I basically forgot this advice and bought multiple $5,000 face value securities recently with the idea I wouldn't have to cash them all if needed. It's unlikely that you'll be desperate for a small amount in any case, and if you need a large amount, at least you'll amortize that $45 fee over more dollars of face value.The Chicago Fed isn't involved in selling TIPS to retail customers, they work directly with dealers, and will try to get a price quote from at least three registered government security dealers before selling your note. But you don't get a say in whether or not the offer price is to your liking, it simply goes to the high bidder. The assumption is that there's enough of this going on all the time that you'll get the fair market value.The Chicago Fed will send you a 1099-B form, and you'll have to sit down and calculate your gain or loss on the sale. TreasuryDirect does not calculate the reportable profit or loss on the principal for you. They do calculate the amount of interest that would have been due to you through the sale date, which of course, you get taxed on.

A few concluding notes. TreasuryDirect apparently doesn't automatically cancel future purchases that you may have planned to finance with the matured security. I don't know who sets up recurring purchases for multi-year securities, but if you did, you might wake up one morning and find an embarrassing hole in your bank account if you gave TreasuryDirect the right to pull money from it, and forgot to cancel the rest of the purchase schedule when you sold the security through the Chicago Fed. TIPS are eligible for STRIPS (Treasury's Separate Trading of Registered Interest and Principal of Securities) , which allows you to separate, or strip, the interest from the principal. That's how you get paid the interest semi-annually, rather than compounding it. The downside is, the interest earned is taxed in the year it's earned. And unlike I-Bonds, where all of the gains are tax deferred until maturity or cash-in, even the principal adjustments of your TIPS are reportable in the year they are made. So, if you don't purchase your inflation protected treasuries through a tax deferred retirement account, you end up with a charge at tax time for owning the things.

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