Recommendations: 9
I very much hope that this is a moot point  that we will never have to deal with the deflation beast during our lifetimes. But since the dword seems to be heard more often these days, I thought it was a good idea to familiarize myself with how deflation affects TIPS & IBonds. Quite differently, as it turns out.
Let's start with a $1000 (theoretical) 1.5% fixedrate IBond purchased in Nov 2002. Let's suppose that inflation is 2% annualized for the previous 6month period, giving the IBond a 3.5% total rate. If my calculations are correct (and they very well may not be, as I did them quickly), that will give a value of $1017 on May 1, 2003.
NOW let us assume that for the next 4 6month periods, the CPIU is an annualized 2%. How much is the IBond worth at the end of this period? $1000? Less than $1000? The correct answer is, $1017. Here's the relevant verbage from the government site: In the rare event that the CPIU is negative during a period of deflation and the decline in the CPIU is greater than the fixed rate, the redemption value of your IBonds will remain the same until the earnings rate becomes greater than zero.
Now, on to TIPS. To make it easy (if unrealistic), let's assume the same starting values & conditions: A $1000 TIPS with a 1.5% fixedrate, and the 2% annualized inflation rate for the preceding period. At the end of the first, 6month period, the TIPS principal amount is $1010 ($1000 + 1/2 of the 2% inflation adjustment), and an interest payment of $7 is paid. (Admittedly, I don't know the exact mechanics involved with TIPS interest payments, so forgive the fact that, for example, the inflation adjustment is likely a different period than the IBond. For simplicity sake, I'd like to pretend the % is the same in both cases.)
So, at the end of the 6month period, its value is $1010, and you've received $7, for a total return of $1017, just like with the IBond. NOW what happens, if during the next 4 6month periods, the CPIU is an annualized 2%. How much is the TIPS worth at the end of this period, and how much interest will have been collected? Will it be more, less, or identical to the IBond?
Well, if my calculations are correct, the TIPS will be worth $970, and you will have collected $30 in interest, for a total value of $1000. Again, here's the relevant government text: Like other notes and bonds, Treasury InflationIndexed Securities pay a fixed rate of interest. But this fixed rate of interest is applied not to the par amount of the security, but to the inflationadjusted principal. So, if inflation occurs throughout the life of your security, every interest payment will be greater than the previous one. On the other hand, in the rather unusual event of deflation, your interest payments will decrease.
So, does that mean IBonds are better than TIPS during a deflationary period? Not necessarily; in fact, I don't think there's any way to predict which would be better, ahead of time. For one thing, the government guarantees that when your TIPS matures, you will get back no less than par value. So, if you were to buy a $1000, 10year TIPS, and there was deflation during the entire 10year period, you would have collected (steadily diminishing) interest payments for 10 years, and you'd then get your original $1000 back. An IBond purchased under those same conditions, however, would get no interest, and be worth $1000 after 10 years. There are probably other scenarios under which the TIPS would come out on top as well.
Perhaps someone else can take this further, but I think that's enough detail for this exercise. My point was just to learn how deflation affects these securities, & pass that learning on. I feel like I've accomplished the former, and hopefully the latter as well.
Ken



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