TIPS and CIPS

Inflation-protected securities can help manage risk in your clients’ portfolios.

by Richard F. Boes, Franklin J. Plewa and Mark Bezik

EXECUTIVE SUMMARY

TIPS are a relatively new form of bond from the federal government that offer protection against the risk of inflation. They combine a high degree of safety of the principal with a hedge against inflation. Potential investors in TIPS may bid for them at auction in either a competitive or noncompetitive process. Competitive bidders submit an offer for a specified number of shares and a desired yield. The Treasury determines which bids are accepted based on the amount of securities requested and their desired yields. Noncompetitive bidders, on the other hand, are guaranteed to receive at least some securities, because they agree to accept a predetermined yield. TIPS may be held until maturity or sold at any time in the secondary market. TIPS generate taxable income to their holders through semiannual cash interest payments that are taxed as interest income and inflation adjustments to the bond principal amount. Corporations have issued similar corporate inflation-protected securities (CIPS). These are issued with a specified rate of interest that is periodically adjusted for inflation. Unlike TIPS, CIPS appreciation is paid out monthly; therefore, CIPS react more quickly to changes in interest rates and provide more income over their term. Richard F. Boes, CPA, PhD, and Franklin J. Plewa, CPA, PhD, are professors of accounting, and Mark Bezik, PhD, is an associate professor of accounting, at Idaho State University in Pocatello. Their e-mail addresses are boesrich@cob.isu.edu, plewfran@cob.isu.edu and bezimark@cob.isu.edu, respectively.

hen we invest in debt securities, we accept different types of risk: credit risk (the risk of default by the issuer of the debt), inflation risk (loss of purchasing power), liquidity risk and real or “true” interest rate risk (the risk that future interest rates will rise or fall over the life of the debt being held). Federal government debt securities always have offered a level of protection against some of these risks, as government debt carries extremely low credit risk (because of the government’s ability to raise revenue through taxation) and these securities are highly liquid, as there is a ready market for disposing of them before maturity.

Since the late 1990s, the federal government has been introducing new forms of debt in an attempt to also protect consumers against inflation risk. The U.S. Treasury has made available two types of bonds: I bonds and Treasury inflation-protected securities (TIPS). Because they combine the highest degree of safety of principal with a hedge against inflation, TIPS may be very attractive to clients of CPAs. We will provide an overview of TIPS, examine their tax implications, and compare and contrast them with corporate inflation-protected securities (CIPS). (For more on I bonds, see “EE vs. I Bonds: Which Are Better?” JofA, Sep.04, page 31.)

HOW TIPS WORK
TIPS are bonds that mature over 5, 10 or 20 years. They provide the holder with a fixed rate of interest applied to an adjusted principal balance. The fixed rate of interest is determined as of the date the securities are auctioned; the principal amount is adjusted for inflation semiannually. This adjusted principal amount is used to calculate the interest that will be paid to TIPS holders. As with I bonds, inflation for TIPS currently is measured using the Consumer Price Index for All Urban Consumers (CPI-U), which is issued monthly by the Bureau of Labor Statistics. This index may either increase or decrease the bond principal amount. The investor is paid neither the principal amount nor the total interest earned until the bond’s maturity date.

Example 1. James Bond purchased a 10-year TIPS bond with a face amount of $1,000 on the issue date of July 15, 2006, with no accrued interest. The TIPS were issued with an annual interest rate of 4%; for the first interest payment period, the CPI-U measured inflation at 1%. The principal value of the TIPS first would be adjusted to $1,010 (1,000 x 1.01). This adjustment would result in a semiannual interest payment of $20.20 [(4% ÷ 2) x $1,010)]. Thus, Bond’s income would be the $20.20 interest payment and the $10 increase in the principal amount.

These adjustments fully protect the investor against inflation on a pretax basis. Not considering taxes, the yield determined on the auction date becomes the real yield for the investor; both the semiannual interest payments and the principal balance that will be paid when the note/bond matures are adjusted for the most recent period of inflation.

HOW TO OBTAIN TIPS
Investors can purchase TIPS through the Treasury Direct Program, which is available at regular intervals during the year. Currently, the Treasury auctions new 5-year TIPS in April and October, 10-year TIPS in January, April, July and October, and 20-year TIPS in January and July. The auction date establishes the sales price of the securities and the stated interest rate that will apply to the principal balance over the life of the TIPS.

Potential investors in TIPS have two ways to bid for new securities: competitive bidding or noncompetitive bidding. In competitive bidding the potential investor submits a tender form indicating the par amount of securities desired (in multiples of $1,000) and the desired yield percent, stated to three decimal places (for example, 4.123%). The maximum competitive bid allowed is 35% of the par value of the securities being offered. Once the bidding process is closed, the interest rate yield for all successful bidders is determined based upon the competitive bids received. The Treasury starts with the lowest yield that was bid and the amount of principal bid at that yield. It then works its way up the yields that were bid until it reaches the total competitive amount available for sale.

Noncompetitive bidding assures that bidders receive at least some securities, because the bidder agrees to accept a yield determined at the time of the auction. A noncompetitive bidder indicates the face value amount of securities that he or she wishes to purchase on a tender form, in $1,000 increments. The minimum bid is $1,000 and the maximum is $5 million. A noncompetitive bidder cannot also be a competitive bidder in the same TIPS auction.

Example 2. There are $11 billion par-value 10-year TIPS being offered for sale:

Four competitive bids are received:

Starting with bidder 4 at the lowest yield (3.000%), the $5 billion face amount would be accepted. To reach the $10 billion total available to competitive bidders, another $5 billion must be accepted. This level will be reached with bidders 2 and 3, each of whom bid 3.200%. Each bidder will receive $2.5 million of bonds (a proportionate share of the amounts for which they bid) but bidder 1 will not receive any of the bonds. Since the $10 billion available to competitive bidders was reached with bidders 2 and 3, the yield for all bidders will be set at what they bid—3.200%. The determined yield then will be used to set the initial stated rate of interest and the initial price for the TIPS.

SELLING TIPS
TIPS may be held until maturity or sold at any time through a securities broker or the U.S. Treasury’s Sell Direct program. When selling through the Sell Direct program, the seller completes a “Request for Sale” form and sends it to the Federal Reserve Bank of Chicago (FRB Chicago). FRB Chicago then obtains quotes from different securities brokers and sells the security for the highest offered price. The proceeds, minus a $34 transaction fee for each security sold, are then deposited into the seller’s checking or savings account. Details of each sale are documented for the seller in three ways: (1) a sales confirmation issued after each sale, (2) a statement of account issued periodically (depending on the frequency of activity) and (3) an IRS form 1099 issued at the end of the year.

TIPS also qualify for the Treasury’s Separate Trading of Registered Interest and Principal of Securities (STRIPS) program, under which the principal and interest rights can be sold separately. If held to maturity, the bond will be redeemed at the adjusted principal balance. As an added safety provision, the Treasury will redeem the TIPS bond/note at face value if deflation should cause the adjusted principal balance to fall below the face value at maturity.

THE TAXATION OF TIPS
TIPS generate taxable income to their holders in two ways: The semiannual cash interest payments are taxed as ordinary interest income and the inflation adjustments to the bond principal are taxed as original issue discount (OID). Holders of TIPS generally receive two form 1099s from the Treasury at the end of the year: one form 1099-INT, showing the amount of interest paid to the bondholder, and one form 1099-OID, showing the amount by which the principal balance of the TIPS increased or decreased during the year because of inflation or deflation. An inflation adjustment is reported as income and increases the taxpayer’s basis in the bond; a deflation adjustment generally is reported as an offset to the TIPS interest income on schedule B of form 1040. A deflation adjustment decreases the taxpayer’s basis in the TIPS. Any interest income from TIPS is income tax-exempt on the state and local levels. Taxpayers may request that the Treasury Department withhold up to 50% of the interest income to help meet their tax obligations at the end of the year.

Example 3. Jane Smith bought TIPS at a par value of $1,000 with a 3% yield. The inflation rate as measured by the CPI-U was 2% during the first six-month holding period. Under these circumstances the interest income for this period is $35.30:

Because federal tax law does not distinguish between real income and nominal income, TIPS are subject to some inflation risk. In example 3, the $20 inflation adjustment is made to keep Ms. Smith’s purchasing power intact; however, this $20 will be subject to tax. Therefore, the amount of purchasing power lost (the inflation risk) will be the inflation adjustment multiplied by her marginal tax rate.

To further complicate the matter, it is possible for the taxes owed on TIPS to be greater than the cash interest received. This could be a problem if the taxpayer lacks funds to pay the tax and therefore is forced to sell a portion of the securities to cover the shortfall. This may occur when inflation rates are unusually high.

The inflation rate risk and potential lack of funds are illustrated in Table1. The table assumes that investors expect a 1% inflation rate and are demanding a real rate of return of 3% before tax. Therefore, the nominal rate of interest would be set in the market place at 4%—1% to cover the expected inflation and 3% to cover the true yield. The table assumes a marginal tax rate of 30%. With a nonindexed bond (for instance, one not adjusted for inflation), the unexpected inflation rate reduces both the pretax and post-tax real yields by the same amounts. For example, if the actual rate of inflation turned out to be 5% (rather than the expected 1%), the investor’s expected true rate of return before tax would fall from $30 to a negative $10 [(the $40 paid less the inflation component of $50 (5% x 1,000))], a decrease of $40. The aftertax true yield would fall from the expected $18 to a negative $22 (the negative $10 pretax real interest less the $12 tax due). The decrease after taxes is again $40. Table 1 also shows the results for actual inflation rates of 10% and 25%. This illustration further demonstrates that the tax burden does not vary with the inflation rate, because it is based on a percentage of the fixed nominal yield.

In the case of TIPS, if the inflation rate turned out to be 5% (rather than the expected 1%), the bondholder would be paid more than the nominally expected $40 (to insure a true yield of 3%). The $1,000 par value first would be boosted to $1,050, with a resulting cash payment of $31.50 (1,050 x 3% true yield). The total interest may be viewed in a slightly different way:

The real pretax yield is $30 regardless of the inflation rate, since the bond is adjusted for inflation. In other words, the inflation rate does not affect the pretax yield. However, because the inflation adjustments are subject to tax even though they are not “true” interest, the aftertax true yield is affected by the tax rates. At the 5% level of inflation, the $81.50 of taxable income would result in a tax liability of $24.45, thus giving an aftertax true yield of $5.55 ($30.00 – $24.45). If the inflation rate was the expected 1%, the aftertax true yield would be $17.91 ($30.00 – the $12.09 tax due on the $40.30 of taxable income).

Thus, the unexpected inflation causes a decrease of $12.36 on the effective return. However, this $12.36 decrease is better than the $40 decrease that occurred on the nonindexed bond. Note that for 10% and 25% inflation rates, the taxpayer may experience the “lack of funds” problem, since the cash paid to the bondholder is less than the taxes due. Table1, below, further highlights the fact that, when taxes are involved, the bondholder cannot completely eliminate the risk of inflation. (For more on the effects inflation may have on an investor’s choice of investments, see “Worries About Inflation.”)

Cases assume a $1,000 bond (sold at par) with an expected true yield of 3% The market is expecting a 1% inflation rate   Expected true yield (that is, post-inflation) 3.0% Expected inflation 1.0% Nominal rate 4.0% Assumed tax rate 30.0% CASE 1: Nonindexed bond inflation rate   Pretax nominal interest Pretax “true” interest Pretax loss from unexpected inflation Principal inflation adjustment Inflation adjusted rate base Cash interest paid Total taxable interest Total tax due Post-tax “true” interest Post-tax loss from unexpected inflation Expected 1% 40.00 30.00 0.00 0.00 1,000.00 40.00 40.00 12.00 18.00 0.00 If Actual is 5% 40.00 (10.00) (40.00) 0.00 1,000.00 40.00 40.00 12.00 (22.00) (40.00) If Actual is 10% 40.00 (60.00) (90.00) 0.00 1,000.00 40.00 40.00 12.00 (72.00) (90.00) If Actual is 25% 40.00 (210.00) (240.00) 0.00 1,000.00 40.00 40.00 12.00 (222.00) (240.00)   CASE 2: Nonindexed bond inflation rate   Pretax nominal interest Pretax “true” interest Pretax loss from unexpected inflation Principal inflation adjustment Inflation adjusted rate base Cash interest paid Total taxable interest Total tax due Post-tax “true” interest Post-tax loss from unexpected inflation Expected 1% 40.00 30.00 0.00 10.00 1,010.00 30.30 40.30 12.09 17.91 0.00 If Actual is 5% 80.00 30.00 0.00 50.00 1,050.00 31.50 81.50 24.45 5.55 (12.36) If Actual is 10% 130.00 30.00 0.00 100.00 1,100.00 33.00 133.00 39.90 (9.90) (27.81) If Actual is 25% 280.00 30.00 0.00 250.00 1,250.00 37.50 287.50 86.25 (56.25) (74.16)

There is one other cost when TIPS are involved. The Treasury imposes an annual maintenance fee of $25 on accounts of more than $100,000. This fee may be deductible, subject to the investor’s limit on miscellaneous itemized deductions.

CORPORATE INFLATION-PROTECTED SECURITIES (CIPS)
In response to the success of TIPS, a number of companies have begun to offer corporate inflation-protected securities (CIPS) to help investors protect their money against inflation risk. CIPS are new bonds initially offered at par, usually in $1,000 increments. Somewhat like I bonds, the securities are issued with a specified, fixed rate of interest that is periodically adjusted for inflation (or deflation). Like TIPS, the interest payment is adjusted for changes in the CPI-U, thus providing a real rate of return above the inflation rate.

Companies have issued both inflation-linked corporate notes and corporate inflation-protected bonds. The bonds normally are issued in 5-, 7- and 10-year maturities and provide for monthly payments that immediately reflect an increase in inflation.

Unlike TIPS, though, CIPS pay out appreciation monthly and include it in the inflation-adjusted payment over their 5-, 7- or 10-year lives. At maturity, the CIPS principal payment is at par ($1,000). TIPS payments are made on a semiannual basis and do not pay out the inflation-adjusted principal increase. CIPS, on the other hand, react more quickly to changes in interest rates and provide more income over their terms. Since interest is paid monthly, investors can reinvest their interest payments more frequently, and therefore interest compounds at a faster rate. And because CIPS holders do not pay a phantom tax on noncash principal adjustments, a greater portion of their monthly interest payments is available for reinvestment.

» Practical Tips

Because an investor receives most of the inflation adjustment at maturity, suggest TIPS to clients who do not need a current income stream. Recommend CIPS to clients looking for more current income, because of their monthly payments and faster adjustment to inflation. Eliminate the risk of an increase in the inflation rate by placing TIPS in a Roth IRA.

TIPS OR CIPS
TIPS and CIPS offer valuable new investment options that are especially suitable for investors concerned about inflation risk. While similar, each investment alternative offers it own set of advantages.

TIPS pose virtually no credit risk because they are issued by the federal government and their inflation rate is minimal. In fact, the inflation rate risk can be eliminated by placing the TIPS in a Roth IRA, and thus completely eliminating federal taxes on the earnings. TIPS already are income tax-exempt on the state and local levels. They also may be viewed as being back-loaded, since investors receive most of the inflation adjustment at maturity, and so may be better suited to investors who do not need current income (another good reason for placing them in a Roth IRA). Because of their safety, TIPS can be a desirable investment for conservative, risk-averse investors.

CIPS expose investors to the issuer’s general credit risk and are subject to state and local income taxation. They may be viewed as being front-loaded, as investors receive the inflation adjustments throughout the term of the investment, and more desirable than TIPS, because of the monthly payments and faster adjustment to inflation. The yields also tend be higher than that of TIPS, because of the credit risks involved. CIPS also can be placed into retirement accounts to delay or prevent federal taxation; they are, however, subject to state income taxation. Table 2, below, summarizes the similarities and differences of TIPS and CIPS.

TIPS CIPS Issued by Treasury Department Corporations Initial price Set by auction Based on a spread to Treasury bills Interest rate Fixed Variable Principal Variable Fixed Payment periods Semiannual Monthly Inflation measurement CPI-U CPI-U Levels of taxation Federal Federal, state and local Phantom taxes Yes No Maturity value Adjusted value (but not below Par) Adjusted value (but not below Par) Risk Virtually no credit risk Liquidity and credit risk associated with the issuing company. Secondary markets available Yes Yes

Inflation-protected securities (IPS) are among the safest and easiest investments for CPAs and their clients. They are not correlated to stocks or bonds, making them a good vehicle to diversify a client’s portfolio. Investors should be aware, however, that long-term IPS issues can result in short-term volatility in their rates of return, and their complex structure may be hard to understand. In spite of these risks, CPAs should be aware of these investment alternatives and their features to help their clients balance their portfolios and meet their financial goals.