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2007 U.S. Economic Events & Analysis

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10-Year TIPS Auction

Definition
The Treasury sells inflation-indexed securities, also known as TIPS, at regularly scheduled auctions. Competitive bids at these single-price auctions determine the interest rate paid on each issue, which remains fixed. Twenty-three primary dealers (as of July 2006) are authorized and obligated to submit competitive tenders at Treasury auctions. Dealers can hold, resell, or trade the securities with other firms. The Treasury announces the amount, date and time of the 10-year TIPS auction four times a year: January, April, July and October. The 10-year TIPS are usually announced at the beginning of January and July. The April and October announcement calls for a reopening of the previously issued security. In each of the aforementioned months, 10-year TIPS are auctioned in the second week of the month. These TIPS are issued on the 15th of the month; if it falls on a weekend or holiday, then they are issued (settled) on the next business day.

Why Investors Care?
Individual investors can participate in Treasury auctions through a securities dealer or via the Treasury Direct program. Though the Treasury Direct program saves on brokerage commissions, commissions are often nominal and eliminate a lot of paper work and administrative hassle. Brokers facilitate the purchase and sale of Treasuries in the secondary market, which is handy for buying Treasuries at times other than scheduled auctions or with maturities other than those offered by standard new issues.

Interest rates on Treasury securities are determined in the market; the Federal Reserve does not set them. However, bond investors are sensitive to Federal Reserve policy and thus market rates will mirror policy expectations. Usually, bond market players are forward-looking and this means that interest rates on Treasury securities will move in the direction of Fed policy with a lead. As a result, one is more likely to see rising interest rates on Treasury yields during an expansion (and falling yields during economic slowdowns) in advance of policy changes by the Federal Reserve.

TIPS, inflation-indexed securities, are designed to shield investors from inflation-risk. The principal is adjusted for inflation. Instead of getting back your initial investment of $1,000, for instance, you would get $1,000 plus an additional amount tied to the inflation rate. Since there is no inflation premium on the interest rate, interest payments (and yields attached to the TIPS) are lower than for regular Treasury securities. Economists and policymakers consider the differential between yields on 10-Year TIPS and regular 10-Year notes to be a proxy for investors' estimate of inflation expectations.

Primer on Treasuries
Treasury securities, Treasuries, Govies and TIPS all refer to the same type of security: debt obligations of the United States. Maturity refers to the length of the loan to the government. TIPS, which were first offered in 1998, have had maturities of either 5, 10, 20 or 30 years (the last 30-year offering was in 2001). Since 1998, all Treasury securities have had minimum denominations of $1,000 and must be purchased in increments of $1,000.

How TIPS work
The principal amount of the security is adjusted for inflation and is paid at maturity. Securities are redeemed at the greater of their inflation-adjusted principal or par amount at original issue. Interest payments, which are taxable like other Treasuries, are issued twice a year and are based on the inflation-adjusted principal at the time of payment. The index for measuring the rate of inflation is the non-seasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers published each month by the Bureau of Labor Statistics. If this index is materially changed, the Treasury will substitute an alternative index.

You pay $1,000 for a TIPS note and receive interest payments every six months based on the inflation-adjusted principal at the time of payment. If the coupon is 3% and the rate of inflation, for instance, stays at 3%, you get $30 every six months for a total of $60 per year. When the note matures in 10 years, you get back the greater of the inflation-adjusted principal or the $1,000 par amount at original issue.

Investment Profile
Treasuries offer a measure of security unmatched by other investments - the U.S. government guarantees the initial investment (the principal) and the interest payments. With regular Treasury securities, inflation may erode the value of both the principal and interest payments. But TIPS offer an additional level of security, protecting the investor from an onset of inflation. When TIPS are resold in the secondary market, their price could be substantially more or less than the face value. Price fluctuations in the secondary market are based on the economic environment, inflation expectations, Federal Reserve policy, and simple forces of supply and demand. Opportunity risk refers to what could have been earned had the money been invested elsewhere.

Important note: Accrued interest relating to inflation gain, is not paid out until maturity, however, the individual is required to pay federal income taxes on this amount. That's why many financial advisors suggest that these securities be purchased for tax-deferred retirement accounts.