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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35387  
Subject: Re: 5 year TIPS Date: 4/23/2006 10:30 PM
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"If I buy at Auction on Tuesday a $1000 TIP at a coupon rate of 2.125%
then 6 months later they apply an inflation increase of say example 1/2 of 3% = 1.5% per year to the principal.

So, $1000 plus 1.5% inflation = 1015 x ( 1/2 x 2.125%)= $1025.78
For a return of 2.58% for the first 6 months or looking forward to one year about 5.2%.

Assuming I have the basic math down , it appears the only upside to buying TIPS would be if inflation was to be 4% or better. Otherwise wouldn't CD's be just as good?"

Don't think you have the math right, but it is likely a 5-year CD will do as well if you can get a good rate, like Pentagon Fed C.U at 5.67% APY.

Although there are nuances with compounding with TIPS, for the purposes of simple comparison just add a plausible annual average inflation adjustment to the purchase yield and compare with CD yield after state and local income taxes (fudge a little, since TIPS pay and adjust semi-annually and APY is daily, but you're guessing inflation anyway).

So, if the upcoming auction yield is fixed 2.2% (even if coupon is 2.125%) and you have 4% state tax so the Pen Fed CD is really worth about 5.43%, CPI-U adjustments would need to average around 3.1% (with semi-annual compounding) to do as well as the Pen Fed CD. The traders are currently looking at around 2.8% for 5-years.

My guess is that Pen Fed will be the winner,but I don't see any other CDs available (I haven't looked closely) that can be the 2.8% CPI-U adjustment the traders are looking at.

The other thing about TIPS is the "insurance" factor—Ken (PCS) thinks this factor should lead TIPS to have a slight discount in return to same maturity Treasuries. We're willing to sacrifice a little yield if the traders are correct or overestimating in return for the assurance that if they are way underestimating (i.e., inflation takes off) we're covered (at least to the extent CPI-U is relevant to our real lives).





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