Quote:
Originally Posted by TheMentat
Not sure what you are missing, but here is my rationale:
The price you should pay for a bond is the expected future payments, discounted by corresponding interest rates for those terms.
With a regular bond the payments are known with certainty, so we simply discount the future coupon and principal payments by rates found on the yield curve.
With a TIPS, you have to make an assumption about what inflation is going to be over the life of the bond. Using that assumption, you can figure out what your payments will be, and discount those payments the same way as you did with an ordinary treasury bond. With this in mind, if we look at pricing on TIPS, we can see what "the market" believes future inflation will be by comparing them to nominal Treasuries.
If you go and buy a TIPS, and inflation behaves exactly as as "the market" expects, you won't make much more money than if you had simply bought a normal treasury bond (think about it... otherwise you could simply short a nominal bond, and use the proceeds to buy a TIPS, and be guaranteed free money as the coupons on the TIPS were gradually re-indexed higher)
The way you make money on a TIPS (over and above the money earned on a nominal bond) is if inflation turns out to be higher than the market expected when you bought the bond.
Does that make sense?
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I'm still missing something and will need to read up more. I thought you bought TIPS to beat inflation. If inflation goes up so will the interest on your bond. So let's say I bought TIPS 4 years ago and inflation was at 2% my bond would pay 2.5%. Then let's say inflation 2 years later jumps to 4%. My understanding is the rate on my TIPS would reset to 4.5%. So no matter how high inflation goes I'll be .5% (or whatever they pay over inflation) higher. I might be thinking I-bonds but I thought TIPS worked similar to this. Am I correct in that the rate TIPS pay fluctuate with inflation?
If the rate does fluctuate with inflation wouldn't TIPS bought 4 years ago pay the same rate as TIPS being issued today?