ISM Feb interest payment

[FIRE'd@51]

My Feb ISM interest payment hit my Vanguard Brokerage Account yesterday. It was the same as January's - $0.087 per share. I was expecting a drop to $0.07 per share, based on the year-over-year October CPI-U numbers.

Oct 2005 CPI-U = 199.2

Oct 2006 CPI-U = 201.8

inflation adjustment = -1 + (201.8 / 199.2) = 0.0131 => 1.31%

interest rate = 2.05% + 1.31% = 3.36%

interest payment = (0.0336 / 12) x PAR = (0.0336 / 12) x $25 = $0.07 per share

Did anyone else notice this? What am I doing wrong?

 

[justin]

I noticed this too. I thought it would be less (or at least different from last month's). It was exactly the same though. I'm at Fidelity.

 

[wabmester]

based on the year-over-year October CPI-U numbers.

It's been a while since I looked at the prospectus, but I thought they paid based on YoY CPI changes each month. Why are you looking at Oct data?

 

[FIRE'd@51]

It's been a while since I looked at the prospectus, but I thought they paid based on YoY CPI changes each month. Why are you looking at Oct data?

There is a 3-month lag from the start of the interest-rate period.

http://www.sec.gov/Archives/edgar/data/1032033/000110465906002036/a06-1563_2424b5.htm

 

[wabmester]

Yup, I missed that. Looks like your calculation is correct and they overpaid us. I suspect they'll figure it out eventually.

FWIW, I calculated that if they used the change from Nov 2005 - Oct 2006, it would come out closer to what they paid.

 

[justin]

I feel like we are paying Monopoly and we all just drew the Community Chest card "Bank Error in your favor, collect $150". Although in this instance, I only got an extra $10 or so...

 

[wabmester]

Yeah, if I did the math right, the overpayment cost them $51,900 in total. So, they'll probably just eat it.

 

[FIRE'd@51]

Yeah, if I did the math right, the overpayment cost them $51,900 in total. So, they'll probably just eat it.

Well, it would be $119,000 if they made the same error in the OSM's.

I bet the short sellers aren't too happy.

 

[youbet]

Gosh, this board is great! I just noticed the same ISM issue in my Schwab account and was going to post asking if others had noticed it too. But the answer was already here! Super!

On a related subject, I've been thinking about the ISM payout scheme and the fact that it's based on a constant $25 PAR value. Doesn't it seem like that because the real value of the $25 will erode vs. inflation over time, the real value of payouts erodes? That is, the real value of a YOY 3% CPI increment in early years will be more valuable, again in real terms, that a YOY 3% CPI increment in later years?

Or am I just thinking myself into unnecessary confusion?

 

[wabmester]

On a related subject, I've been thinking about the ISM payout scheme and the fact that it's based on a constant $25 PAR value. Doesn't it seem like that because the real value of the $25 will erode vs. inflation over time, the real value of payouts erodes? That is, the real value of a YOY 3% CPI increment in early years will be more valuable, again in real terms, that a YOY 3% CPI increment in later years?

I don't think there's much of a difference between having an inflation-adjusted principal (a la TIPS) and reinvesting the inflation component of ISM back into ISM.

 

[FIRE'd@51]

On a related subject, I've been thinking about the ISM payout scheme and the fact that it's based on a constant $25 PAR value. Doesn't it seem like that because the real value of the $25 will erode vs. inflation over time, the real value of payouts erodes? That is, the real value of a YOY 3% CPI increment in early years will be more valuable, again in real terms, that a YOY 3% CPI increment in later years?

That's an interesting question. Suppose you tried to make the ISM work like a TIPS with the same real rate. To make the example simple, assume the ISM price always stays at 25. Each time you get an interest payment, you would reinvest the inflation component into more shares of ISM. That way your number of shares would increase at the inflation rate, and since the real rate of interest (i.e. the 2.05%) would apply to more shares, your interest payment would also grow with the rate of inflation as well. The ISM would behave just like a TIPS.

 

[GOJAGATORS]

I own OSM as well as ISM and the Feb interest payment on OSM was also exactly the same as the Jan payment. Looks like both issues were overpaid by my calculation.

 

[youbet]

I don't think there's much of a difference between having an inflation-adjusted principal (a la TIPS) and reinvesting the inflation component of ISM back into ISM.

That's an interesting question. Suppose you tried to make the ISM work like a TIPS with the same real rate. To make the example simple, assume the ISM price always stays at 25. Each time you get an interest payment, you would reinvest the inflation component into more shares of ISM. That way your number of shares would increase at the inflation rate, and since the real rate of interest (i.e. the 2.05%) would apply to more shares, your interest payment would also grow with the rate of inflation as well. The ISM would behave just like a TIPS.

I was thinking along those lines as well. Currently, I don't need the current monthly cash flow from ISM interest payments and would just as soon see the principal amount grow with inflation instead of seeing my MM acct grow by a few hundred bux a month. Maybe I'll just buy an incremental 100 shares every few months with the accumulated payouts. Too bad there is no automatic investment feature.

 

[FIRE'd@51]

I was thinking along those lines as well. Currently, I don't need the current monthly cash flow from ISM interest payments and would just as soon see the principal amount grow with inflation instead of seeing my MM acct grow by a few hundred bux a month. Maybe I'll just buy an incremental 100 shares every few months with the accumulated payouts. Too bad there is no automatic investment feature.

If you purchased your ISM at a discount to PAR, you have some of that growth built in already, so you could do what you are suggesting and probably keep pace fairly well.

 

[JohnEyles]

I feel maybe there is a fundamental flaw in the reasoning that ISM provides a
better real return than TIPS - but I stand ready to be corrected.

The bond YTM calculator at:
http://www.moneychimp.com/articles/finworks/fmbondytm.htm

gives for ISM a YTM of 3.56% for the current price of roughly $21.60 (assuming a
$25 par, 11 year duration, and 2.05% coupon). By contrast, YTMs for 5-yr TIPS seem
to be in the 2.4-2.5% range.

So ISM is about a point better than TIPS. *But*, what these YTM numbers really
are is the YTM *IF* inflation is zero, and so we assume inflation is addded to these
caculated YTMs and thus the *real* return is about equal to the calculated YTM.

The problem is that for TIPS the principal grows with inflation and thus so do the
interest payment and the principal returned at maturity. But for ISM, the interest
payment is increased by inflation, but the principal is not. The principal at maturity
is $25, regardless of inflation, and this works out to about 1.34% APY on the principal
(with above assumptions) almost certainly considerably lower than inflation.

Does this make any sense ?

 

[wabmester]

Does this make any sense ?

No.

As has been pointed out, the inflation-adjustment of TIPS is nothing more than the treasury forcing you to reinvest part of your dividends (specifically, the inflation component of the dividend).

As has also been pointed out, you're buying ISM at a discount, which means that the YTM goes up as inflation goes up (since you're getting both the coupon and the inflation adjustment at a discount).

ISM is a good deal.

 

[youbet]

Does this make any sense ?

Yes.

I understand bonds even less than equities, but ISM's payout scheme vs the TIPS payout scheme has been knawing at me all along. I think it's because I've figured out that the incremental additions to principal in TIPS also increase at a rate equal to nominal plus real interest. ISM's PAR value is always $25, regardless of the level of inflation we see between now and maturity.

Once we go through a period of significant inflation, TIPS provides a permanently increased payout because the principal amount has been increased by CPI. With ISM, if after several years of significant inflation YOY cpi dropped to zero for a year, you'd receive 2.05% of $25. So, prices are higher following years of significant inflation, but your payout is low.

Seems like what you do reinvesting the inflation component of the ISM payouts would be key to offsetting this.

I'm kinda confused, so correct me gently if I'm wrong.

 

[FIRE'd@51]

There's another advantage to the ISM structure if you hold the security in a taxable account. In a period of high inflation, the real component of the interest rate in a TIPS may not be large enough to pay the tax due. At least with the ISM structure, the cash flow is always there to pay the tax.