Buying TIPS On Secondary Market, Part 2: Understand Quotes
This is part two of the Guide to Buying TIPS On the Secondary Market. Part one was Why Secondary Market?
The price and yield quotes are perhaps the source of most confusion about buying TIPS on the secondary market. Unlike regular ("nominal") bonds, TIPS are quoted in real price and real yield while the actual purchase is done with nominal dollars. Let's take a look at an actual quote from Fidelity for one specific bond.
There are a bunch a numbers. What do they mean?
Coupon: 2.000. It means this bond will pay 2.000% annual interest rate. All TIPS pay interest twice a year. The interest is calculated as follows
inflation adjusted principal on the interest payment date * coupon rate / 2
Therefore this bond will pay you twice a year 1% (one half of the coupon rate) of the inflation adjusted principal on the interest payment date.
Maturity Date: 01/15/2016. This is when the inflation adjusted principal will be paid back to you. If you need your money back before then, your only choice is selling the bond back on the secondary market. You can also tell by the maturity date when the bond will pay interest. TIPS always pay the last interest on the maturity date. Therefore this bond will pay interests on January 15 and July 15 every year.
Rating: AAA. All Treasury bonds are rated AAA.
Price Bid/Ask: 96.031/96.965. The first number is the bid price, which is the price the dealer pays you when you sell. The second number is the ask price, which is the price you pay the dealer when you buy. When you are buying, pay attention to the ask price. These numbers are expressed as a percentage of inflation adjusted principal (see Inflation Factor discussed below). The ask price of 96.965 means you pay 96.965% of the inflation adjusted principal if you buy this bond from the broker. Some brokers display the prices in a number followed by a multiple of 1/32. For example 96-31 means the whole number 96 plus a fraction of 31/32, which equals 96.96875 in decimal.
Yield Bid/Ask: 2.620/2.471. These are real (after inflation) Yield to Maturity (YTM) expressed in percentages. YTM is an internal rate of return calculation for all the cash flows from a bond. A real YTM is calculated using cash flows in real terms. The first number is the bid yield, which is the yield you give up when you sell. The second number is the ask yield, which is the yield you receive when you buy. For this bond, if you buy at the broker's ask price of 96.965, your real YTM is 2.471%.
Inflation Factor: 1.09333. This is unique to TIPS. The principal value of TIPS is adjusted by this multiplier. It's also called the index ratio. The index ratio changes every day with inflation with a 2-month lag. Around the 17th of every month, when the Consumer Price Index (CPI) number for the previous month is announced, the Treasury department publishes the index ratio for every TIPS bond for the following month. At any point of time, you know what the index ratios will be in the next 15 – 45 days.
When you buy stocks, the unit is one share. When you buy bonds, the unit is one bond. By bond convention, one bond is $1,000 in face value. The inflation adjusted principal is $1,000 multiplied by the index ratio. Therefore the inflation adjusted principal for this bond is $1,093.33. The ever changing index ratio makes your bond keep up with inflation and deflation.
Adjusted Price Bid/Ask: 104.993573/106.014743. These are bid/ask prices multiplied by the inflation factor a.k.a. the index ratio. If you multiply the ask price of 96.965 by the index ratio of 1.09333, you get 106.014743. Because they are a simple multiplication, not all brokers display these in their quotes. Fidelity is showing these numbers here for your convenience.
There is one more piece of data that's not shown in the quote. It's called accrued interest. Accrued interest is the interest between the last interest payment date and today. If you buy the bond today, you will receive six months worth of interest on the next interest payment date. But because the current owner owned it between the last interest payment date and today, it's only fair that they receive a portion of the interest. Therefore when you buy the bond from the current owner, you have to pay them the interest they already earned. Because it's simply an advance, accrued interest is usually not included in the price quote. If you want to know the all-in cost including accrued interest, you can use my spreadsheet:
Spreadsheet: Buying TIPS on Secondary Market
So altogether, the quote is showing you that if you accept the quote and buy this bond, you will have a bond that
- matures on Jan. 15, 2016;
- pays 2% annual interest rate multiplied by the ever changing inflation adjusted principal;
- has an inflation adjusted principal of $1,093.33
- costs 96.965% of inflation adjusted principal ($1,093.33) plus accrued interest
- gives you a real Yield to Maturity of 2.471% (before broker commission)
In addition to these numbers in the quote, if you use my spreadsheet, you will also see
- the all-in cost including accrued interest is $1,069.80518 per bond;
- if you buy 10 bonds and your broker charges you $40 commission, your total cost for 10 bonds is $10,738.05;
- with the broker commission, your real YTM is now 2.413% (versus 2.471% before broker commission).
We will look at when to buy TIPS in part three of this guide.
Software picked, likely related posts:
- Buying TIPS On Secondary Market, Part 1: Why Secondary Market?
- Buying TIPS On Secondary Market, Part 4: What to Buy
- Buying TIPS On Secondary Market, Part 5: How to Buy
Comments
14 Comments on Buying TIPS On Secondary Market, Part 2: Understand Quotes
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Pelon on December 29, 2008 |
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Dave on December 30, 2008 |
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Jim Franke on January 27, 2009 |
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Michael on January 27, 2009 |
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Michael on January 28, 2009 |
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Michael on January 29, 2009 |
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sarah on June 4, 2009 |
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Al Cismesia on October 13, 2009 |
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Is there price competition in the bid-ask spread? For instance, could I find a better ask price at Vanguard over Fidelity, or are they both simply passing on the price as set by a market specialist?
Pelon – Unlike the stock market, where prices are published on stock exchanges by the second, there is very little pricing transparency in bonds for retail investors. Short of having a Bloomberg terminal, you don't know what the true market price is at this moment. The prices you get from different brokers are different. One broker is not necessarily consistently better than another.
Why not construct your spreadsheet to show the $ amount of accrued/adjusted accrued interest rather than the % of principal?
Dave – Thanks for the suggestion. I fixed the spreadsheet.
Since the principal is inflation adjusted, doesn't the yield to maturity rate calculated using the discount or premium only applicable to the non inflation adjusted price paid i.e. the yield on the inflation adjusted amount is the coupon rate?
Jim – When we talk about TIPS, everything is real (unadjusted): real price, real coupon, real yield. Yield on inflation adjusted amount is unknown because future inflation is unknown.
Hi TBF, If one purchases TIPS on secondary market at infl adjusted price of say, 103.30, is it possible that in deflationary environment could drive the price back to 100, and one could conceivably have a negative rate of return?
Michael – Yes, you could have a negative nominal rate of return due to deflation, but after adding back the deflation, your real rate of return can still be positive. See previous post TIPS During Deflation for details.
In short, when you buy a TIPS bond on the secondary market, be confident that your real YTM will never go lower than the quote even if there’s deflation after you buy the bond.
Thanks TBF. You make the above comment in your article, TIPS During Inflation. Just want to clarify the following. . .
Let's look at an example. I purchase a TIPS on the secondary market.
2.5 percent due 7/15/06
inflation factor 1.05385
price 102.992
gross price 108.53831
current yield 2.427
yield to maturity 2.065
Let's say we have deflation and the inflation factor slips to 1.03 at maturity (I know, highly unlikely). Wouldn't my yield to maturity be less than the quoted YTM above of 2.065?
I guess I am wondering if the inflation factor can go down as well as up over time?
Thanks so much, I appreciate your help!
Michael – If you are talking about the real yield (after inflation), no, it will not be less than 2.065% if there is deflation. That's what that entire article was about. The nominal yield (with inflation, in this case deflation), can be lower than 2.065%, or even negative. The inflation factor can go down as well as up over time, but it will not negatively affect the real yield.
Aha! I get it. Thanks so much TFB.
I'm getting hung up on "breakeven levels" and am not sure i understand them. the breakeven level on the current 10 year tip is 1.93%. do i interpret that to mean that if i think inflation will be higher than 1.93% then this 10year TIP is unattractive at this level and I wouldn't want to buy unless the breakeven level is over 2%. Thank you!
No it's backwards. Breakeven refers to the difference between the yield on TIPS and the yield on regular Treasurys. If you think inflation will be higher than the breakeven, TIPS is a better deal than regular Treasurys. In other words, the breakeven is the price you pay by accepting a lower yield up front, hoping inflation will make up for it. As when you buy anything, you want that price to be low.
Thank you for your pricing info. I have called Fidelity at least 6 times trying to decipher the numbers in the various quote columns. Never have I gotten an explanation that made much sense. But thanks to you, I'm finally headed down the path of understanding. Thanks again.
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