(Some Finance Questions) - Research Paper Example

24 November Treasury Inflation Protected Securities (TIPs) TIPs is a treasury security to protect investors from the negative effects of inflation. TIPs is a unique asset class which is dollar denominated, inflation protected and backed by the Government (US Treasury) as a result considered as extremely low risk investment. The U.S Treasury has been issuing TIPs since 1997. The principal of TIPs increases with the inflation and decreases with deflation as the principal is tied to the consumer price index.

However, on maturity the investor is guaranteed at least the original principal amount invested, thereby protecting from any deflationary situations. TIPs pay interest semi-annually at a fixed rate which is calculated on the adjusted principal to make the interest payments as well inflation driven (Treasury Direct). The market of TIPs is the world largest inflation indexed securities market with over $550 billion of TIPs outstanding i.e. approximately 8% of the total debt market of treasury. TIPs can be purchased directly from Treasury Direct system with a minimum purchase limit of $100 and multiples of $100 thereof and are available with 5-, 10-, and 30-year maturities.

The 5-year and 30-year TIPs are auctioned semi-annually whereas 10-year TIPs are auctioned quarterly. The auction bids are TIPs are submitted both as competitive and non-competitive. In case of competitive bids, the bidder specifies the yield that he/she is willing to accept the security for. In case of non-competitive bid, the yield is determined at the auction which the bidder agrees to accept for a security. TIPs are issued in electronic form and can be like other marketable securities which can be held to maturity or sold before it matures.

Interest paid on TIPs is subject to federal taxes but are exempted from both state and local taxes. At maturity, the securities are redeemed at inflation adjusted principal or original principal, whichever is greater. TIPs were introduced in 1997 with the aim of providing a new security to the investors who wanted protection of the uncertain inflationary condition of economy. Secondly, TIPs also provided the Government of reducing the borrowing cost for the U.S treasury, as these securities did not include inflation risk premium unlike the conventional bonds.

However, since 1997, there is has been no empirical evidence which proves that TIPs has reduced the cost of borrowing, as the liquidity premium on TIPs has been exceeding the inflation risk premium. To explain the TIPs market, let us compare the structure of TIPs to a normal conventional U.S. Treasury bond. A 3.5% 10-year U.S treasury would provide $17.50 as semi-annual coupon and $1,000 (par value) in principal value on maturity. On the contrary, 10-year TIPs paying 1.3% of coupon and assuming 5% inflation rate would get $ 6.

83 as coupon payment and a the principal amount will increase to $1050 at the end of 1st year and end up as $1628.895 on maturity. The difference between in yield between the conventional treasury and TIPs is called inflation breakeven (Watson). The start of recession in the year 2008, led to TIPs getting affected by both deflationary fears and liquidity issues. Similar to most asset classes, TIPs also performed badly in 2008 but it bounced back relatively in 2009. The returns from TIPs turned negative in last 3 quarters of 2008 but bounced back sharply in 2009 with returns as high as 11.

4% (Watson). In 2008, the interest rate on TIPs was 1.75% and as per the last auction on 17th Feb 2011, this interest rate has risen to 2.125. However, this is not the case with the volumes. In 2008, a total of $9 billion worth of TIPs were accepted which drastically reduced in the second half of 2008 to just $6.5 billion. Even though the interest rate increased to 2.5% the volumes did not pick up in 2009 and went to as low as $6 billion. However, in 2010 TIPs bounced back with high volumes touching $8 billion and again dropped to $ 7.

17 billion in the second half. The year 2011 has been a beneficial year for TIPs as volumes touched to $9.4 billion with yields at 2.13% (Treasury Direct). Works Cited Treasury Direct. TIPS. n.d. Web. 11 April 2011. US Treasury. TIPS. n.d. Web.11 April 2011. Watson, Towers. "TIPS." n.d. Towers Watson. 11 April 2011.