Ming FuApril 30th

STRIPS and TIPS

STRIPS = Separate Trading of Registered Interest and

Principal of Securities

Introduction of STRIPS

Principal STRIPS(hen)

Coupon STRIPS (eggs)

Treasury Bond

Coupon

Stripping

History of STRIPS

TIGRsBy Merrill Lynch

Treasury Income Growth Receipts

CATSBy Salomon Brothers

Certificates of Accrual on Treasury Securities

COUGARsBy A.G. Becker Paribas

Coupon Government Accrual Receipts

LIONsBy Lehman Brothers

Lehman Investment Opportunities Notes

DOGs

Dibs On Government Securities

An Example of STRIPS

U.S. Treasury Bond3 Years to Maturity

Semiannual Coupons

An Example of STRIPS (cont’d)

Year Price of Treasury bonds Price of Treasury STRIPS

0.5 $60/(1.04)1 = $58 $60/(1.020)1 = $59

1.0 $60/(1.04)² = $55 $60/(1.025)² = $57

1.5 $60/(1.04)3 = $53 $60/(1.030)3 = $55

2.0 $60/(1.04)4 = $51 $60/(1.035)4 = $52

2.5 $60/(1.04)5 = $49 $60/(1.0375)5 = $50

3$60/(1.04)6 = $47 $60/(1.04)6 = $47

$1000/(1.04)6 = $790 $1000/(1.04)6 = $790

Total $1,103 $1,110

• $1,000 principal with 12% Coupon rate and 8% Yield To Maturity

$7 profit !!!

Compare Yield to Maturity

Summary of STRIPS

Principal Coupons

TIPS = Treasury Inflation Protection Securitiesor

TIIS = Treasury Inflation Index Securities

First TIPS in 1997

Introduction of TIPS

U.S. Treasury Bond3 Years to Maturity

Semiannual Coupons

Adjusted Principal=Principal*(1+inflation rate)

Coupon payment=Adjusted Principal*fixed coupon rate

*Inflation based on Consumer Price Index-Urban Consumers (CPI-U)

Inflation

An Example of TIPS

Year Inflation(Annual)

Inflation(Semi-A)

Principal Coupon(Annual)

Coupon(Semi-A)

CouponPayment

0.0 $1,000 4% 2%

0.5 2% 1% $1,010 4% 2% $20.20

1.0 3% 1.5% $1,025.15 4% 2% $20.50

1.5 4% 2% $1,045.65 4% 2% $20.91

2.0 5% 2.5% $1,071.79 4% 2% $21.44

2.5 2% 1% $1,082.51 4% 2% $21.65

3.0 1% 0.5% $1,087.92 4% 2% $21.76

1025.15=1010+1010*1.5% 20.5=1025.15*2%

Year Deflation(Annual)

Deflation(Semi-A)

Principal Coupon(Annual)

Coupon(Semi-A)

CouponPayment

0.0 $1,000 4% 2%

0.5 -2% -1% $990 4% 2% $19.8

1.0 -3% -1.5% …… 4% 2% ……

1.5 -4% -2% …… 4% 2% ……

2.0 -5% -2.5% …… 4% 2% ……

2.5 -2% -1% …… 4% 2% ……

3.0 -1% -0.5% $917.83 4% 2% $18.36

An Example of TIPS (cont’d)

Deflation on TIPS

You have this safeguard at maturity:

If the adjusted principal < the original principalYou are paid the original principal!

Coupons are still paid based on deflationary principal.

1983-2012 U.S. CPI-U (in %)

Latest deflation in the U.S. was in 1954.

Summary of TIPS

• The great inflation hedge• No free lunch: opportunity cost

Alternative investment: municipal bonds? We will see in Marcus’s presentation soon

Reference• http://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_faq.htm• http://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips.htm• http://www.treasurydirect.gov/instit/research/faqs/faqs_basics.htm• http://www.raymondjames.com/fixed_income_tips.htm• http://

www.jpmorgan.com/tss/General/Tips_on_TIPS/1300313797124%2Bcorrelation+of+nominal+and+real+yields&oe=utf-8&rls=org.mozilla%3Aen-GB%3Aofficial&client=firefox-a&channel=np&hl=en&ct=clnk

• http://www.newyorkfed.org/aboutthefed/fedpoint/fed42.html• http://

www.finra.org/Investors/InvestmentChoices/Bonds/SmartBondInvesting/typesofbonds/P133240

• http://seekingalpha.com/article/107144-tips-strips-redux

Thank you!

Questions?

Appendix

35 TIPS