A. Please explain the difference between TIPS and STRIPS. Under what economic si
ID: 2783034 • Letter: A
Question
A. Please explain the difference between TIPS and STRIPS. Under what economic situation would it be advantageous to purchase TIPS? Please provide an example of how TIPS bonds work.
B. What is the advantage of issuing bonds with call provision? Why do investors purchase callable bonds when they have to forfeit (or sell back) these bonds to the issuing corporation in the future?
C. What is the difference between competitive bidding and noncompetitive bidding for Treasury Securities? Please provide an example of how the treasury auction process works. Be very precise.
Explanation / Answer
A. TIPS is an abbreviation for Treasury Inflation Protected Securities. They are a type of inflation indexed bonds. Inflation indexed bonds are those which make payments according to the movements in a general price index or the price of a particular commodity (for example oil bonds in major oil producing nations such as Venezuela, Mexico, Nigeria,etc).When the bond payments are tied to (indexed to) the movements in the general price index (that measures inflation) it is known as a inflation protected bond which is exactly what TIPS is.
TIPS are useful when the economy is going through a phase of highly volatile inflation rates, which make real returns on investments extremely uncertain. (The relation between real returns and TIPS is elaborated in the example given below)
The working of a TIPS bond and its relation to ensuring real return to investors is shown through the example given below :
Suppose, we have a TIPS with the figures Par Value=$1000, Coupon Rate= 6% per annum, Maturity = 3 years and makes annual coupon payments. Additionally, let the inflation for the next 3 years be 3%,4% and 5% respectively.
Therefore, at the end of one year owing to a 3% inflation the par value changes to 1000x 1.03=$1030. Since, the coupon payment is 6% (a fixed) of the par value, the coupon payment at the end of year 1 would be 0.06 x 1030=$61.8. Now since the par value rose by 3% (as the bond is inflation indexed), the coupon payment which is a fixed 6% of the par value also increases proportionally. Therefore, the cash flows provided denote a real return of 6% per annum irrespective of the existing inflation rate. Infact, since the return of 6% is absolutely certain (assuming no risk other than inflation risk exists) , it is a risk free real return of 6% per annum on the TIPS.
The nominal return (non inflation protected) on the bond would be = (Coupon Payment + Capital Accumulation) / (Initial Investment) = ( 61.8 +30) / 1000 = 0.0918 or 9.18% (which is not inflation adjusted and hence higher than the real return)
STRIPS is an abberviation for Separate Trading of Registered Interest and Principal Securities, which is in fact a process through which 'coupon stripping' is performed. Before, discussing coupon stripping we need to know about a related concept called 'zero coupon bonds'(ZCB). A ZCB is a bond which has no coupon payments during its period of existence and straightaway pays back the bond par value at the time of the bond's maturity. Consequently, all the gains in a ZCB is through its capital accumulation (price appreciation) as there is only one cash flow to the investor and they sell at a discount to the par value.
The process of creating multiple equal maturity ZCBs from a long term bond is known as 'bond stripping' and the Treasury program under which the same is undertaken is known as STRIPS. An example of bond stripping would be a 5 year semi-annual coupon paying bond which is 'stripped' of its 10 semi-annual coupon payments and each coupon payment is treated as a zero coupon bond.