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CHAPTER 6 TREASURY AND AGENCY SECURITIES MARKETS ANSWERS TO QUESTIONS FOR CHAPTER 6 2. The following questions are about Treasury Inflation Protected Securities (TIPS). (a) What is meant by the “real rate”? In terms of TIPS, the real rate is the coupon rate. This is discussed below. On January 29, 1997, the U.S. Department of the Treasury issued for the first time Treasury securities that adjust for inflation. These securities are popularly referred to as Treasury inflation protection securities, or TIPS. The first issue was a 10-year note. Subsequently, the Treasury issued a 5-year note in July 1997 and a 30-year bond in 1998. TIPS work as follows. The coupon rate on an issue is set at a fixed rate. That rate is determined via the auction process. The coupon rate is called the “real rate” since it is the rate that the investor ultimately earns above the inflation rate. The inflation index that the government has decided to use for the inflation adjustment is the nonseasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U) (b) What is meant by the “inflation-adjusted principal”? For TIPS, the inflation-adjusted principal is the principal that the Treasury Department will base both the dollar amount of the coupon payment and the maturity value on. It is adjusted semiannually. Part of the adjustment for inflation comes in the coupon payment since it is based on the inflation-adjusted principal. However, the U.S. government has decided to tax the adjustment each year. This feature reduces the attractiveness of TIPS as investments in accounts of tax-paying entities. Because of the possibility of disinflation (i.e., price declines), the inflation-adjusted principal at maturity may turn out to be less than the initial par value. However, the Treasury has structured TIPS so that they are redeemed at the greater of the inflation adjusted principal and the initial par value. An inflation-adjusted principal mus