In 1997, the U.S. Treasury Department began issuing “Treasury Inflation-Protecte
ID: 1199253 • Letter: I
Question
In 1997, the U.S. Treasury Department began issuing “Treasury Inflation-Protected Securities,” commonly called TIPS. TIPS are bonds whose interest rates and principal payments are adjusted upward for increases in the price level. For example, if inflation increases 2 percent in a given year, then TIPS increase by, say, 3 percent. Which of the answer choices best explains why an individual might want to include TIPS in an investment portfolio
Investors prefer other assets that, unlike TIPS, promise to pay a much higher real interest rate.
A.Investors prefer other assets that, unlike TIPS, promise to pay a much higher real interest rate.
B. TIPS provide a low-risk, inflation-proof asset, guaranteeing real purchasing power in the future. C. Issued and backed by the U.S. government, TIPS have a significant default risk, meaning the expected return on the investment is low. D. Since annual inflation in the U.S. is usually less than 2 percent, interest rates on TIPS are low. This enables the Treasury Department to borrow more easily at a lower current cost.Explanation / Answer
b.Tips provide a low risk inflation proof asset, guaranteering real purchasing power in the future.
for example- assume a $1,000-U.S. TIPS was purchased with a 3% coupon; also assume inflation during the first year was 10%. If this were the case, the face value of the TIPS would adjust upward by 10%, to $1,100. Furthermore, the coupon payment (3%), which is also based on face value, would be $33 (payments adjust and are paid semi-annually). The end result is that not only are interest payments protected against inflation, but so is the bond's face value, which is returned to the investor at maturity. Traditional nominal bonds offer neither of these protections.
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