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Author: KenAtPcs Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35387  
Subject: Deflation effects on TIPS & I-Bonds Date: 9/30/2002 12:58 AM
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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 d-word seems to be heard more often these days, I thought it was a good idea to familiarize myself with how deflation affects TIPS & I-Bonds. Quite differently, as it turns out.

Let's start with a $1000 (theoretical) 1.5% fixed-rate I-Bond purchased in Nov 2002. Let's suppose that inflation is 2% annualized for the previous 6-month period, giving the I-Bond 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 6-month periods, the CPI-U is an annualized -2%. How much is the I-Bond 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 CPI-U is negative during a period of deflation and the decline in the CPI-U is greater than the fixed rate, the redemption value of your I-Bonds 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% fixed-rate, and the 2% annualized inflation rate for the preceding period. At the end of the first, 6-month 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 I-Bond. For simplicity sake, I'd like to pretend the % is the same in both cases.)

So, at the end of the 6-month period, its value is $1010, and you've received $7, for a total return of $1017, just like with the I-Bond. NOW what happens, if during the next 4 6-month periods, the CPI-U 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 I-Bond?

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 Inflation-Indexed 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 inflation-adjusted 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 I-Bonds 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, 10-year TIPS, and there was deflation during the entire 10-year period, you would have collected (steadily diminishing) interest payments for 10 years, and you'd then get your original $1000 back. An I-Bond 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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