Question: If the big reason for the appreciation in TIPS is that they are institutionalized and that buyers-have bid up the price based on general U.S. T-bond levels (rather than inflation alone, then it might be wise to sell them. Is this the whole story? What are the factors in pricing TIPS?
Answer: There are at least two factors contributing to the price of TIPS: price of Treasuries; and TIPS as an inflation hedge. Unlike TIPS, Treasuries are relatively risk free, very liquid and actively traded. The market for TIPS is not as big or as liquid as for traditional Treasuries. There may be other factors about which we do not know. Also, we do not know how to weight these factors.
Lately, TIPS prices have been moving up in conjunction with Treasuries. However, we have not seen inflation in some time, and don’t know when it will appear next. Thus, we don’t know how TIPS will move if there is a spike in inflation. With inflation, we would expect Treasury yields to rise and prices fall. However, we do not know if TIPS will continue to track Treasury yields and prices in that scenario because they are considered an inflation hedge. Accordingly, we have no idea how TIPS prices will move. To further complicate the picture, the TIPS are trading in an institutional market, not a retail market. Who know what strategies institutional traders have devised.
Question: Counting just the principal and inflation adjustment, what level of inflation would equate to the current TIPS price level?
Answer: TIPS are generally compared to traditional Treasuries. With the 10-year Treasury at 2 percent, TIPS are generally considered a good investment if you can project inflation at more than 2 percent.
Question: Here is another question that I should know, but am not quite embarrassed enough not to ask (even though I just reread the chapter in your book): Does the Government (a) payout the inflation adjustment every six months or (b) adjust the principal? In the case of deflation, I guess it can only adjust the principal, so the answer must be (b)? What am I missing?
Answer: The government just pays out the coupon, but not the inflation adjustment in cash. However, you have to report for tax purposes the inflation adjustment each year. If your TIPS are held in a retirement account, this does not apply to you. In the case of deflation, the face value of the TIPS is adjusted downward, but cannot go below 100, the par value of the bond.