Anyone understand exactly how TIPS work

[GTM]

I understand I bonds fixed rate plus infaltion rate equals return. If you buy an I bond you will receive 6.73% for the next six months then it can change.

If you buy a $10,000 five year TIP tomorrow and hold it for five years
What is your return?
and How is it calculated?

 

[Gone4Good]

If you buy a $10,000 five year TIP tomorrow and hold it for five years
What is your return?

No one knows the answer to this question. Its like asking "if I buy a stock, what will my return be in 5 years?"

The only thing you know is what the REAL return will be on your TIPS, which is the bond's current yield. The amount you receive in addition to the current yield will depend on the future CPI readings, which aren't known today.

 

[GTM]

No one knows the answer to this question.  Its like asking "if I buy a stock, what will my return be in 5 years?"

The only thing you know is what the REAL return will be on your TIPS, which is the bond's current yield.  The amount you receive in addition to the current yield will depend on the future CPI readings, which aren't known today. 

OK lets say hypothetically the CPI remains exactly the same for 5 years. (anyone know what the last data was).
How much would your $10,000 TIP be worth in 5 years.

What is the exact formula?

 

[MasterBlaster]

Compound interest formula:

A= amount in the account with interest.

P= principal, the amount you start with.

r = rate of interest, the percent.

n = number of times the interest is calculated per year, that is 12 times for monthly, 365 times for daily.

t = time the principal is in the account and is measured in years.

 

[Gone4Good]

OK lets say hypothetically the CPI remains exactly the same for 5 years. (anyone know what the last data was).
How much would your $10,000 TIP be worth in 5 years.

What is the exact formula?

Your $10K compounds semiannually at the rate of CPI.
You receive checks in the mail equal to the fixed rate * your original principal adjusted for CPI.

I don't know if there is a simple formula to determine what the total return of a TIPS security is. I doubt it because the assumption of constant inflation is unrealistic. More likely you'll have to set this up in Excel and calculate the IRR yourself.

 

[wabmester]

OK lets say hypothetically the CPI remains exactly the same for 5 years. (anyone know what the last data was).
How much would your $10,000 TIP be worth in 5 years.

As you know, TIPS have a fixed interest rate and a variable inflation index.    Today, the fixed rate is around 2%, and inflation is around 5%.   TIPS compound twice a year.   So, if inflation stayed at 5%, your total return on $10,000 should be $14,106 after 5 years.

Reality is different.   The inflation index is applied to the principal every 6 months, and the fixed rate is then applied to the adjusted principal.   So, you'll get a variable amount of interest even if inflation stays constant, and then you'll get an inflation-adjusted principal back at maturity.

Edit: another difference between i-bonds and TIPS is that i-bonds automatically compound. With TIPS, the interest is distributed to you, so it's up to you to reinvest it to get the equivalent compounding.