Personal Investments • TIPS Secondary Market Math

Investment cost can be much higher than par after adjusting for inflation index and discount or premium. Assuming no deflation, does one get his/her investment cost plus subsequent inflation adjustments at maturity (in addition to coupon payments)?

If you hold to maturity, you can always count on the applicable yield to maturity on your original investment in real terms.
With massive deflation you can do even better, but that is usually thought to be an unlikely scenario.

So forget about thinking in nominal terms. Nominal returns are meaningless if you don't factor inflation. If the YTM is 2% and you hold to maturity , you can count on your investment returning your principal adjusted for inflation plus 2% annually (compounded). That is all that really matters.

If you sell prematurely, all bets are off.

Thanks. Yes, I understand what you posted (except doing better with massive deflation). I was just asking about the starting point for the adjusted principal.

In the case of deflation you will get at least the quoted YTM in real terms.
In the case of EXTREME deflation, you will get rich.

To wrap my head around consequences I like to simplify things by thinking of the most extreme examples I can imagine.

Consider this:
You are thinking of buying a house with your life savings of $500K. But instead, you put off the purchase a year and invest the $500K in 1 year TIPS with a YTM of 1%.
Over the course of the year, there is 99% deflation.
At maturity, you only receive face value ($500K) (add to that your 1% return- I will ignore that for simplicity).
But now, the house you wanted to buy only costs $5K! You can now buy 100 similar houses, whereas before you could only afford one!!
Even if you paid a whopping $5M for the face value $500K TIPS on the secondary market, and only received $500K at maturity, you could still buy 90 more similar houses than you could on the day you invested!

Bottom line....unless the government financial system collapses, you will always be guaranteed at least your yield to maturity in real terms (minus what you pay in federal taxes, but when withdrawn you would pay federal tax on other fixed income investments as well, and maybe state tax too).

Does that help?

Statistics: Posted by protagonist — Thu Aug 15, 2024 4:19 pm — Replies 10 — Views 408

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