Our article last week, Opportunities and Risks in TIPS, elicited questions from several readers regarding whether TIPS priced at a discount to par are more valuable than those priced at a premium. The question arises for TIPS because they are protected at par at maturity – the Treasury guarantees that the final principal payment will be at least 100, offering an advantage in a deflationary environment.
For nominal Treasury bonds this question is moot. It is relevant for TIPS in a deflationary environment but not an inflationary one.
It turns out that discount bonds are more valuable, but the market may already be pricing them appropriately.
Consider the following two 19-year TIPS, using pricing data obtained from Bloomberg at the close of business on May 22:
Coupon |
Maturity |
Bid Price |
Yield |
Accrued |
1.750 |
1/15/28 |
90.30 |
2.352 |
101.4 |
3.625 |
4/15/28 |
117.27 |
2.439 |
131.4 |
These bonds differ in maturity by only three months and their yields differ by nine basis points. The first is priced at a discount and the second is a seasoned issue, with substantial accrued principal, priced at a premium.
The bonds’ performance differs markedly under different deflationary assumptions, but is consistent if inflation ensues:
Assumed Annual CPI Change (%) |
Discount Bond IRR (%) |
Premium Bond IRR (%) |
Performance Advantage of Discount Bond |
-3 |
1.94 |
1.72 |
22 |
-2 |
2.06 |
1.93 |
13 |
-1 |
2.20 |
2.18 |
2 |
0 |
2.35 |
2.44 |
-9 |
1 |
3.37 |
3.46 |
-9 |
2 |
4.39 |
4.49 |
-10 |
