Treasury Inflation Protected Securities (TIPS) are bonds issues by the US Treasu
ID: 1170675 • Letter: T
Question
Treasury Inflation Protected Securities (TIPS) are bonds issues by the US Treasury that protects the investors against inflation. They have a much lower coupon rate, but the face value is indexed to inflation every coupon period. Hence, if you start with a face value of $1,000, and general level of prices tripled in 30 years, and your coupon rate is 1% APR, as your last payment, you will get $3,000 times 0.5% (semi-annual) which is $15 as coupon payment plus $3,000 as payment of the face value indexed for inflation. A regular bond pays only $1,000 as face value payment plus whatever the coupon maybe. Currently, yields on regular Treasury Bonds for 10 and 30-year maturity are 2.90% and 3.05% respectively. The yields on TIPS with 10 and 30-year maturity are 0.80% and 0.94% respectively. Taking the difference gives for 10 and 30-year maturities gives 2.10% and 2.11%. Controversial Claim Since the market essentially assuming that average rate of inflation will be about 2.10% for the next 30 years or so, we should BUY TIPS and SELL Regular Bonds. Claim Objective Students are expected to argue in favor of positions they may not necessarily agree with, and in the process, learn to understand where opposing views come from Such skills are necessary to stay away from "incestuous amplification" that arises from groups of people who think alike. You are required to defend the statement made as if it was made in a court of law in front of a judge.Explanation / Answer
30 Year Treasury Assuming Face value $1000 Inflation rate 2.10% Inflation adjusted principle in year (N+1)=1.021*(Inflation adjusted Principle in Year (N) N A B=A*0.0305 C=B/(1.0305^N) D E=D*0.0094 F=E/(1.0305^N) Regular Bond TIPS Year Principal Coupon Present Value of Coupon Inflation adjusted principal Coupon Present Value of Coupon 1 $1,000 $30.50 29.59728287 $ 1,021.00 $ 9.60 $ 9.31 2 $1,000 $30.50 28.72128372 $ 1,042.44 $ 9.80 $ 9.23 3 $1,000 $30.50 27.87121176 $ 1,064.33 $ 10.00 $ 9.14 4 $1,000 $30.50 27.04629962 $ 1,086.68 $ 10.21 $ 9.06 5 $1,000 $30.50 26.24580264 $ 1,109.50 $ 10.43 $ 8.97 6 $1,000 $30.50 25.4689982 $ 1,132.80 $ 10.65 $ 8.89 7 $1,000 $30.50 24.71518505 $ 1,156.59 $ 10.87 $ 8.81 8 $1,000 $30.50 23.98368273 $ 1,180.88 $ 11.10 $ 8.73 9 $1,000 $30.50 23.27383089 $ 1,205.68 $ 11.33 $ 8.65 10 $1,000 $30.50 22.58498873 $ 1,231.00 $ 11.57 $ 8.57 11 $1,000 $30.50 21.91653443 $ 1,256.85 $ 11.81 $ 8.49 12 $1,000 $30.50 21.26786456 $ 1,283.24 $ 12.06 $ 8.41 13 $1,000 $30.50 20.63839356 $ 1,310.19 $ 12.32 $ 8.33 14 $1,000 $30.50 20.02755319 $ 1,337.71 $ 12.57 $ 8.26 15 $1,000 $30.50 19.43479203 $ 1,365.80 $ 12.84 $ 8.18 16 $1,000 $30.50 18.85957499 $ 1,394.48 $ 13.11 $ 8.11 17 $1,000 $30.50 18.30138282 $ 1,423.76 $ 13.38 $ 8.03 18 $1,000 $30.50 17.75971161 $ 1,453.66 $ 13.66 $ 7.96 19 $1,000 $30.50 17.2340724 $ 1,484.19 $ 13.95 $ 7.88 20 $1,000 $30.50 16.72399069 $ 1,515.36 $ 14.24 $ 7.81 21 $1,000 $30.50 16.229006 $ 1,547.18 $ 14.54 $ 7.74 22 $1,000 $30.50 15.74867152 $ 1,579.67 $ 14.85 $ 7.67 23 $1,000 $30.50 15.28255364 $ 1,612.84 $ 15.16 $ 7.60 24 $1,000 $30.50 14.83023157 $ 1,646.71 $ 15.48 $ 7.53 25 $1,000 $30.50 14.39129701 $ 1,681.29 $ 15.80 $ 7.46 26 $1,000 $30.50 13.96535373 $ 1,716.60 $ 16.14 $ 7.39 27 $1,000 $30.50 13.5520172 $ 1,752.65 $ 16.47 $ 7.32 28 $1,000 $30.50 13.15091431 $ 1,789.45 $ 16.82 $ 7.25 29 $1,000 $30.50 12.76168298 $ 1,827.03 $ 17.17 $ 7.19 30 $1,000 $30.50 12.38397184 $ 1,865.40 $ 17.53 $ 7.12 SUM 593.9681363 SUM $ 245.07 Present Value of Maturity(1000/(1.0305^30) 406.0318637 Present value of payments $ 1,000.00 TIPS BOND: Present value of Coupons $ 245.07 Present Value of Maturity $ 757.41 (1865.40/(1.0305^30) Present value of payments $ 1,002.49 TEN YEAR BOND: N A B=A*0.0290 C=B/(1.0290^N) D E=D*0.0080 F=E/(1.0290^N) Regular Bond TIPS Year Principal Coupon Present Value of Coupon Inflation adjusted principal Coupon Present Value of Coupon 1 $1,000 $29.00 28.18270165 $ 1,021.00 $ 8.17 $ 7.94 2 $1,000 $29.00 27.38843698 $ 1,042.44 $ 8.34 $ 7.88 3 $1,000 $29.00 26.61655683 $ 1,064.33 $ 8.51 $ 7.81 4 $1,000 $29.00 25.86643035 $ 1,086.68 $ 8.69 $ 7.75 5 $1,000 $29.00 25.13744446 $ 1,109.50 $ 8.88 $ 7.69 6 $1,000 $29.00 24.42900336 $ 1,132.80 $ 9.06 $ 7.63 7 $1,000 $29.00 23.74052805 $ 1,156.59 $ 9.25 $ 7.57 8 $1,000 $29.00 23.07145583 $ 1,180.88 $ 9.45 $ 7.52 9 $1,000 $29.00 22.42123988 $ 1,205.68 $ 9.65 $ 7.46 10 $1,000 $29.00 21.78934876 $ 1,231.00 $ 9.85 $ 7.40 SUM 248.6431462 SUM $ 76.66 Present Value of Maturity(1000/(1.0290^10) 751.3568538 Present value of payments $ 1,000.00 TIPS BOND: Present value of Coupons $ 76.66 Present Value of Maturity $ 924.92 (1231.00/(1.0290^10) Present value of payments $ 1,001.58 Present value of Future Payments: 10 Year 30 Year Regular Bond $1,000 $1,000 TIPS Bond $ 1,001.58 $ 1,002.49 In both cases , The Value of TIPS Bond is slightly higher than regular Bond Hence Buy TIPS and Sell Regular Bond Claim is correct based on above data
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