Inflation Protection: The Trouble with TIPS
A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise, and as interest rates rise, the prices of debt securities tend to fall. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. Longer-term debt securities are usually more sensitive to interest-rate changes. The longer the maturity date of a security, the greater the effect a change in interest rates is likely to have on its price.
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Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements.
TIPS (Treasury Inflation-Protected Securities) are U.S. Treasury securities indexed to inflation in order to protect investors from the negative effects of inflation. The principal of a TIP is adjusted according to the CPI-U. With a rise in the index, or inflation, the principal increases. With a fall in the index, or deflation, the principal decreases. Though the rate is fixed and paid semi-annually, interest payments vary because the rate is applied to the adjusted principal. Specifically, the amount of each interest payment is determined by multiplying the adjusted principal by one-half the interest rate. Upon maturity, TIPS pay the original or adjusted principal amount, whichever is greater. Because TIPS are adjusted for inflation, a change in real interest rates (but not nominal interest rates) will affect the value of TIPS. When real interest rates rise, the value of TIPS will decline, and when real interest rates fall, the value of TIPS will rise.
The coupon is the rate of interest stated on a fixed-income security. It is expressed as a percentage of the principal or face value of the security.
The Consumer Price Index (CPI) measures the price changes f or each item in a predetermined basket of goods and services, and the inputs are weighted according to their importance to consumers.
Correlation is a statistical measure that describes the strength of relationship between two variables. It can vary from 1.0 to -1.0.
CPI Swaps are derivative instruments used to hedge inflation risk by transferring inflation risk from one party to another through an exchange of cash flows.
Duration is a measure of the sensitivity of the price of a fixed-income asset to a change in interest rates and is expressed in years.
Exchange Traded Fund (ETF) is a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold.
A five-year zero coupon inflation swap enables investors to increase or decrease their exposure to the risk of inflation. An income stream that is tied to the rate of inflation is exchanged for one with a fixed interest rate.
The Bloomberg Barclays U.S. Treasury Index is the U.S. Treasury component of the U.S. Government Index. The index includes public obligations of the U.S. Treasury with a remaining maturity of one year or more.
The Bloomberg Barclays U.S. TIPS Index is an unmanaged index comprised of U.S. Treasury Inflation Protected Securities with at least $1 billion in outstanding face value.
The Deutsche Bank U.S. CPI Breakeven Inflation 5-Year Swap Indexes allow investors to track the performance of five-year inflation swaps. These measure the performance of holding an inflation receiver, breakeven payer swap. The inflation swaps are based on the U.S. CPI Urban Consumers Index.
Indexes are unmanaged, do not reflect the deduction or expenses, and are not available for direct investment.
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