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Treasury Inflation-Protected Securities (TIPS)

TIPS have gained a lot of attention lately as the Fedís accommodative monetary policy is potentially paving the way for future inflation. The NCUA has recently approved the purchase of TIPS for federally-insured credit unions in an attempt to provide them with a tool to hedge against inflation. They are currently an authorized investment.

In theory, TIPS appear to be a nice hedge against inflation. In practice, it is highly unlikely credit unions will view this as a suitable investment. We believe this is a non-starter for most (if not all) of our clients. First, most will balk when they see a negative yield (discussed below). Second, accounting for these instruments might be difficult enough for most credit unions to pass on the idea. Lastly, credit unions have no inflation-indexed liabilities and little to no experience monitoring inflation risk, so the need for inflation-indexed investments seems unlikely.

The issue of negative yield can be seen in the TIPS issue that matures on 4/15/17. The stated coupon on this bond is 0.125%. That bond is currently trading at a dollar price of 108.00 which produces a negative current yield of -1.75%. To this current yield is added the CPI rate as described below. If inflation is running at 2.00%, then the net current yield on this note for the next six months would be 0.25% {(-1.75%) + (2.00%)}. Needless to say, this is well below the current market yield for a fixed-coupon bond to this same maturity date (0.65% currently).

TIPS yields increase as inflation rises, but that benefit costs money and therefore produces a lower current yield. Please note that deflation can reduce the future value of the notes. Historically, the U.S. has not experienced many bouts of deflation, but lower inflation might also produce a less-than-desired result.

The following information was taken from the U.S. Treasury web site:

The U.S. Treasury has been issuing Treasury Inflation-Protected Securities (TIPS) since 1997. TIPS provide investors with protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Bureau of Labor Statistics Consumer Price Index for All Urban Consumers (CPI-U): U. S. City Average, by expenditure category and commodity and service group (not seasonally adjusted).

When a TIPS matures, the investor is paid the inflation-adjusted principal or original principal, whichever is greater. Since a TIPS investor won't receive less than the original principal, the investor's original principal amount is protected against deflation as well.

TIPS pay interest semiannually at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation. All TIPS accrue interest from the 15th of the month and are issued on the last business day of the month. For original issue TIPS, accrued interest is payable by the investor from the 15th until the issue date. For reopened TIPS, accrued interest is payable from the dated date on the announcement until the issue date of the reopening.

All TIPS accrue interest from the 15th of the month and are issued on the last business day of the month. For original issue TIPS, accrued interest is payable by the investor from the 15th until the issue date. For reopened TIPS, accrued interest is payable from the dated date on the announcement until the issue date of the reopening.

Adjusting TIPS Principal

Each month, the U.S. Treasury publishes daily index ratios that are used to adjust the principal of TIPS. The index ratios are based on the latest changes to the Bureau of Labor Statistics Consumer Price Index for All Urban Consumers (CPI-U): U. S. City Average, by expenditure category and commodity and service group(not seasonally adjusted). View the Historical Reference CPI Numbers and Daily Index Numbers Historical Reference CPI Numbers and Daily Index Numbers. The principal of a TIPS increases with inflation and decreases with deflation.

Tax Considerations

Interest on TIPS is exempt from state and local taxes but is subject to federal tax. TIPS investors pay federal income tax on interest payments in the year they are received and on growth in principal in the year that it occurs.

For more information on Treasury Inflation-Protected Securities, contact your Business Development Officer at 1-877-786-2677.

All securities are offered through CU Investment Solutions LLC (ISI). The home office of ISI is located at 8500 West 110th Street #650, Overland Park, KS 66210. ISI is registered with the Securities and Exchange Commission (SEC) as a broker-dealer under the Securities Exchange Act of 1934. ISI also is registered in the state of Kansas as an investment advisor. Member of FINRA and SIPC. All investments carry risk; please speak with your representative to gain a full understanding of said risks. Securities offered by ISI are not insured by the FDIC, Corporate or NCUSIF and may lose value. All opinions, prices and yields are subject to change without notice.

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