Lesson 5 of 8
Treasury inflation-indexed securities (TIIs) are issued by the US Treasury Department and represent direct obligations of the U.S. government. The key feature of these securities is that they provide investors protection against the rise in inflation.
Since they are backed by the full faith and credit of the government, there is minimal credit risk. The Treasury securities are primarily sold through banks as primary dealers. Banks can also sell the securities in the secondary markets and invest their own money in them.
Characteristics
The primary purpose of TIIs is to provide long-term investors protection/hedge of their principal against the rise in inflation.
For each new TII issue, the initial par amount is indexed to the non-seasonally adjusted Consumer Price Index for All Urban Consumers (CPI-U).
The index ratio is determined by dividing the current CPI-U level by the CPI-U level that applied at the time the security was issued or last re-indexed.
If there is deflation, the principal value can be reduced below par at any time. However, if the inflation-adjusted principal amount is below par even at maturity, the security will be redeemed at par.
Interest is paid every sixed months based on a fixed rate determined at the initial auction. The interest is calculated based on the inflation-adjusted principal amount.
TIIs are also eligible for Treasury STRIPS program, and can be stripped to interest and principal components.
TIIs do not provide any tax benefit and investors must pay tax on the accretion to the principal amount of the security, even though the increase in principal is not received in cash. The tax payment reduces the effective yield on the security.
Let’s take an example to understand how TIIs work. Let’s say you purchase a $1,000 note at the beginning of the year, in which the interest rate set initially is 4%. Assume that inflation for the first year is 5%. At the end of year 1, the $1,000 principal would be $1,050, after adjusting for inflation. The investor will receive 4% interest payment on the increased principal balance of $1,050. The above example assumed that the interest payments will be made annually, however, it will actually be semi-annual in reality.
Uses of Treasury Inflation-Indexed Securities
An investor in TIIs is expecting the real interest rates to fall. Real interest rate is the nominal rate of interest minus the inflation rate.
If nominal rates fall, but inflation does not, there is a decrease in real interest rates. TIIs will appreciate because their fixed coupon will now represent a more attractive rate relative to the market.
If inflation rises, but nominal rates rises more, there is an increase in real interest rates. The TII will decrease in value because it will only partially adjust to the new rate climate.