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Author: junkman02 Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35400  
Subject: The Bet That Underlies Buying TIPS Date: 7/27/2009 1:43 PM
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The Bet That Underlies Buying TIPS

#1, The current interest-rate on 20-year TIPS is 2.50%. Treasury interest is exempt from state taxes. Therefore, a buyer would pay would pay just the ordinary-income tax-rate of 15% (or more, depending on his tax situation). That would reduce the effective interest-rate to 2.125% (or lower).

#2, The principal part of the derivative is indexed to the CPI. Therefore, a TIPS buyer is shorting the CPI (aka, is buying a derivative that provides the inverse of the CPI). That gain, if any, is also taxed but not exempt from state taxes. Everyone’s tax situation will be different. But let’s guess a 20% combo, Fed-State tax rate.

#3, The CPI is deliberately manipulated, so as to understate consumer-experienced inflation (just as the GDP is over-stated). But if one is buying the exact basket of goods and services on which the CPI is based, then his personally-experienced rate of inflation will exactly that of the CPI.

#4, Let’s guess that the forward-rate of the CPI over the next 20 years averages 2.5% (or roughly the Fed/Treasury’s target). A present-day buyer of TIPS whose personally-experienced rate of inflation is exactly that of the CPI will receive an after-tax return of 2.125% in interest and lose an after-tax 0.50% on inflation, for a net real-gain of 1.625%.

#5, However, to the extent that the difference between his personally-experienced rate of inflation and the manipulated CPI is greater than 1.625% (which amounts to a rounding error when talking about inflation), then he will fail to achieve an real rate of return, all other things being equal.

#6, Thus, a present-day TIPS buyer is making the following bet. He is betting that the difference between his total gains from buying the derivative will be only modestly eroded by the effect of taxes and the likely difference he will experience between the reported value of the CPI and his personally-experienced rate of inflation.

#7, Is that a good bet to make, or is it a very risky one? That’s a question each person will have to decide for himself.

#8, Personally, I’d rather take on the up-front risks of an honest junk bond that will pay a pre-tax 15-20% (or better) rather than a cockamamie, government-issued derivative whose most likely return is a assured loss.

#9, But, then, what would I know about bond investing and achieving real-rates of return, on average and over the long haul?

Have a nice day.
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