Question

You buy a TIPS at issue at par for $1,000. The bond has a 3.2% coupon. Inflation turns out to be 2.2%, 3.2%, and 4.2% over the next 3 years. The total annual coupon income you will receive in year 3 is _________.

Answer 1

TIPS stands for Treasury Inflation Protected Securities. They are unique in the sense that their par value/face value is altered as per the prevailing inflation rate. This is done so that the value of their periodic coupon payments are inflation adjusted. This would be achieved if the par value is adjusted annually (or periodically) for inflation, as the coupon payments are entirely based on the securities par value.

Inflation is 2.2%, 3.2% and 4.2% over Year 1, Year 2 and Year 3.

Therefore, Security Par Value after Year 3 = 1000 x (1.022) x (1.032) x (1.042) = $ 1099.001568

Annual Coupon in Year 3 = Annual Coupon Rate x Year 3 Par Value = 0.032 x 1099.001568 = $ 35.1680 or $ 35.17 approximately.