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iApples and iOranges: Comparing CIPS With TIPS

This paper is a work-in-process and is not complete. Please do not distribute except to
point to http://www.inflationinfo.com/iApples_and_iOranges.pdf. All comments
welcome.

Michael Ashton, CFA


m.ashton@enduringinvestments.com
or you can find me on Bloomberg.

Article:
Today there are two common structures traded in the U.S. inflation-linked bond
market: Treasury Inflation-Indexed Securities (colloquially known as TIPS) and
Corporate Inflation-Protected Securities (collectively known as CIPS). These two types
of securities have significantly different structures, although the degree of this difference
is obscured by the similarity of the names. This paper will describe the difference
between these two sorts of bonds and describe the inherent difficulties involved in
comparing them.
How TIPS Work:
The U.S. Treasurys version of inflation-linked bonds is based on what is often
called the Canadian model. A TIPS bond has a stated coupon rate, which does not change
over the life of the bond and is paid semiannually. However, the principal amount on
which the coupon is paid changes over time, so that the stated coupon rate is paid on a
different principal amount each period. The bonds final redemption amount is the greater
of the original par amount or the inflation-adjusted principal amount.
Specifically, the principal amount changes each period based on the change in the
Consumer Price All Urban Non-Seasonally Adjusted Index (CPURNSA)1, which is
released monthly as part of the Bureau of Labor Statistics CPI report. The CPURNSA
for a given day is called the Reference CPI (Ref CPI). In order to create a daily series
from a monthly data point (e.g., so as to accurately account for accrued interest), the
Treasury defines the daily Ref CPI as follows:

Note that this series is also abbreviated NSA CPI from time to time; I have chosen to use CPURNSA
because that also happens to be the tag for the Bloomberg index series: CPURNSA<Index>.

The Ref CPI for the first day of a month is equal to the CPURNSA for
the month three months prior. For example, the Ref CPI for June 1st is
the March CPURNSA, which was reported in April.

The Ref CPI for any other day of the month is straight-line interpolated
based on the number of calendar days in that month. For example, the
Ref CPI for June 10th would be (9/30 * CPURNSAApr) + (21/30 *
CPURNSAMar).

The current principal value of a TIPS bond is equal to the original principal times
the Index Ratio for the settlement date. The Index Ratio for a particular bond on a given
day is defined as the Ref CPI for that day divided by the Ref CPI that applied to the day
the bond was issued. This latter value is referred to as the Base CPI of the bond.2
The Bureau of the Public Debt reports the Ref CPI (which is the same on any
given day for all bonds) for each day and the Index Ratio (which differs for each bond,
since each one has a different Base CPI) for each bond on each day as they become
calculable, on its website at http://www.publicdebt.treas.gov/of/ofhiscpi.htm. But
although there are quite a few terms involved, the actual calculation is quite simple.
To illustrate how TIPS work, consider the example of a bond in its final pay
period. Suppose that when it was originally issued, the Ref CPI for the bonds dated date
(that is, its Base CPI) was 158.43548. The Ref CPI for its maturity date, it turns out, is
201.35500. The bond pays a stated 3.375% coupon. The two components to the final
payment are as follows:

N.b. The CPURNSA is rarely revised, but it does happen. The issue specifications for TIPS, however,
dictate that once the Base CPI is set for a bond, it becomes a permanent characteristic of that bond no
matter what future revisions to the CPI occur. This means that the Base CPIs for some bonds may not
precisely match what would be implied from the CPURNSA series as that series now stands, revised.

(1) Coupon Payment = Rate * DayCount * Stated Par * Index Ratio


= 3.375% * * $1000 * (201.35500/158.43548)
= $21.45
(2) Principal Redemption = Stated Par * max [1, Index Ratio]
= $1000 * (201.35500/158.43548)
= $1,270.90
Notice that it is fairly easy to see how the construction of TIPS protects the real
return of the asset. The Index Ratio of 201.35500/158.43548, or 1.27090, means that
since this bond was issued, the total rise in the CPURNSA that is, the aggregate rise in
the price level - has been 27.09%. The coupon received has risen from 3.375% to an
effective 4.2892%, a rise of 27.09%, and the bondholder has received a redemption of
principal that is 27.09% higher than the original investment. In short, the investment
produced a return stream that adjusted upwards (and downwards) with inflation, and then
redeemed an amount of money that has the same purchasing power as the original
investment. Clearly, this represents a real return very close to the original real coupon
of 3.375%.3
How CIPS Work:
One traditional complaint over the years about the structure of TIPS, especially
from taxable investors, has been that the tax treatment of the inflation uplift to the
principal imposes onerous record-keeping and reporting duties on the investor. The uplift
of principal, or accretion, is taxable to investors as phantom income in a manner similar
to the way zero coupon bonds convergence to par is treated. Since the investor is being
3

It isnt exactly 3.375% in real terms because the inflation index looks back three months and this lag
introduces a subtle mismatch between the inflation period covered by the bond and the actual inflation rate
experienced by the holder during the holding period. This subtle mismatch becomes less subtle for CIPS.

taxed on earnings not yet received, some investors have expressed a preference to receive
the protection of the original principal the accretion along with the periodic coupon
payment.4
Another concern expressed by retail investors and issuers of corporate notes is
that it is not known with a TIPS structure what the amount of the next coupon will be
until the Index Ratio for the coupon date is set.5 An issuer of a TIPS-style security that
pays a coupon on the 15th of July will not know what the coupon payment will be until
the May CPI figure is released in mid-June, because the May CPURNSA represents the
Ref CPI for August 1st and the interpolation to July 15th requires that number. TIPS were
designed with such a short lag because that would more effectively match the inflation
period covered by the bond with the inflation rate experienced by the holder during the
holding period, but the implication for a corporate treasurer is that his precise cash flow
needs arent known until mere weeks before the coupon or principal redemption is due to
be paid.
The response from Wall Street was to produce a structure often referred to as a
current-pay bond, in which the coupon itself varies with inflation but the nominal amount
of the principal remains unchanged. When these bonds are issued by corporate entities,
they are referred to as CIPS. A CIPS bond has a stated coupon rate, to which is added the
most-recent year-on-year (Y/Y) inflation rate. The coupon is paid monthly, and the
nominal amount of the principal never changes. The result is a roller-coaster coupon that
4

Since the accretion is merely compensation designed to preserve the real value of the principal, a change
in tax policy to ignore this accretion in the calculation of taxable income would be a simple way to correct
for the absurdity of being taxed on an increase in nominal value that doesnt reflect a real return on capital.
Thought of another way, to make the inflation adjustment tax free would represent inflation-indexation. Of
course, this would create a dilemma in that it would represent preferential tax treatment for TIPS over
nominal Treasuries (after all, part of Treasuries return is compensation for expected inflation).
5
Of course, the theoretically-pure way to look at this is to observe that the number of real dollars is known
with good precision; its just that the nominal value of those real dollars keeps changing.

is higher when recent inflation has been high, and lower when recent inflation has been
low. By contrast, the TIPS coupon is much more stable, gently rising over time with
inflation.
To illustrate how CIPS work, consider this example: A bond is issued with a
3.375%+CPI monthly coupon. Suppose that over the last year, the CPURNSA has risen
from 190.00000 to 195.70000 (that is, 3% inflation). The coupon payment is calculated
as follows:
(3) Coupon = (Rate + Y/Y CPI) * Day Count * Par Amount
= [3.375% + (CPURNSAt-3/CPURNSAt-15 1)] * 1/12 * $1000
= [3.375% + (195.7/190.0 1)] * 1/12 * $1000
= 6.675% * 1/12 * $1000
= $5.3125.
Notice that the coupons of this structure will, at least initially, be higher than in
the TIPS structure because in the latter, the inflation rate is multiplicative with the
coupon (3.375% * 1.03, for example, since the inflation is compounded into the principal
and this has the effect of increasing the coupon similarly) while in this structure the
inflation rate is additive (3.375% + 3%). This has clearly been one reason the CIPS
product has met with some reasonable success: it is easier to sell 6.375% than it is to sell
3.47625%. Of course, the TIPS buyer is being paid too in the form of principal accretion;
moreover, the inflation compounds over time another year of 3% inflation causes the
TIPS coupon to rise to 3.375% * 1.03 * 1.03 whereas for CIPS there is no compounding
and the coupon for year two is the same as for year one: 3.375%+3%. Figure 1 illustrates

that over time, the effects of this compounding alone will have a small but important
effect on the total return of the instrument.
FIGURE 1 will show representative components of return graphically: real coupon,
inflation, accretion, reinvestment of coupons

An aside: To fairly compare the aggregate total returns, it is necessary to make


assumptions about the reinvestment rate which the coupons earn after being paid to the
bondholder until the maturity of the bond. Because CIPS earn the reinvestment rate on a
larger coupon, at least for a while, the actual difference in total returns may be more or
less than Figure 1 suggests. However, since retail investors rarely reinvest coupons in the
optimal manner, this observation does have implications for the suitability of CIPS for
these investors. To protect against inflation even marginally as effectively as TIPS-style
bonds, the CIPS investor must manage the cash flows in a very hands-on way, reinvesting
the coupons into other CIPS. In a sense, TIPS handle the reinvestment of a good portion
of the cash flow automatically by rolling it into the principal.
There is another important observation to make about Equation 3. The monthly
CPI fixing used for the coupon is based on the actual CPURNSA index value three
months ago (CPURNSAt-3), versus the index value from fifteen months ago (CPURNSAt15).

This is a very significant difference between TIPS and CIPS, and one that greatly

increases the difficulty of fairly comparing the two structures. I will address that
difficulty below; for now, notice that the period of inflation covered by the CIPS
structure does not match up very well with the holding period of the bond. Since the
lookback window rolls forward every month, some months inflation is represented in

each of 12 consecutive coupons while other months inflation (the ones at either end)
may be represented in only a handful.
Inflation Protection
100%

80%

60%

Only the first


coupon paid
incorporates
inflation from
t-15 to t-14

Only the last


coupon paid
incorporates
inflation from
t19 to t20

40%

20%
Holding Period from t-1 to t23
0%
-15

-12

-9

-6

-3

12

15

18

21

24

Time (months from first coupon payment)

Figure 2: The holding period of this 2-year CIPS is from t-1 to t23 (t0 is when the first coupon is paid).

Figure 2 illustrates the inflation protection conferred by a 2-year CIPS bond and
makes clear that during the final year of such a security the amount of protection
provided against inflation diminishes since each monthly coupon confers only onetwelfth of the inflation experienced that month. In exchange for this diminished
protection, the bondholder receives in the first year some protection against inflation
that has already occurred and is known.
Since the inflation for the period from t-15 to t-3 is, in fact, already known, there is
no protection at all for that period, nor indeed any unusual compensation for that
period. To see this, consider a one-coupon CIPS bond that pays 2%+CPI. If the inflation

experienced from t-15 to t-3 was, say, 3%, then this coupon will be at a rate of 5% and is
known at the time of purchase. If other one-month paper is yielding 6%, why would an
investor purchase this CIPS? If other one-month paper is yielding 4%, why would anyone
buy anything but this CIPS? Although it is called an inflation-protected security, no
security will provide any protection against events whose outcome is already known.
Therefore, a 2-year CIPS bond provides more like 1 year of full protection, and 1 year of
diminished protection, against inflation. Furthermore, because of the long lookback part
of the CIPS coupon is actually nominal rate compensation masquerading as a real rate.
The latter point will become more clear in the next section.

The Value of Mismatched Inflation Periods


A TIPS bonds confers full, and even, protection for most of the holding period,
while a CIPS bond confers uneven protection that does not match particularly well with
the holding period, especially for a short-maturity CIPS. How do these facts affect the
interplay between the relative values of these sorts of securities? I will consider three
cases: constant inflation, rising inflation, and falling inflation (disinflation). For each
comparison, I will consider a 2-year TIPS-structure with a real coupon of 2% and a 2year CIPS that pays CPI+2% in the style described above.6 Both are priced at par.

A. Constant Inflation:
Consider an environment in which monthly inflation is constant at a 3%
annualized rate. The aggregate income flows for both bonds are illustrated in Figure 3.
6

N.B. Of course, since TIPS are sovereigns and CIPS are the obligations of corporate entities, we would
not expect them to have the same yield. For ease of comparison, however, I have set them equal here; so I
will say the bond is a TIPS-style bond rather than an actual TIPS.

The blue line shows the inflation rate, constant at 3%; annualized inflation over the whole
holding period is 3.042% (it is slightly greater than 3%, of course, because it compounds
monthly). The cumulative income for the TIPS structure is 10.329% (4.153% in coupons
+ 6.176% in uplift of additional principal at maturity), for an annually-compounded
return of 5.038%. Unsurprisingly, this means the bond returned almost exactly the stated
2% real yield (5.038%-3.042% = 1.996%).
The cumulative income for the CIPS is similar at 10.083%. With level inflation,
the difference in lookback is unimportant, but the lack of compounding on the inflation
payment is non-negligible. The annualized yield works out to 4.921%, which means the
CIPS bond in fact returned only a 1.879% real yield (4.921% - 3.042%). For the simple
case in which inflation is stable, then, the TIPS structures compounding on only a 2-year
note turns out to be worth some 11.7 basis points.7

As noted previously, if the holder of the CIPS invests his or her coupons in another inflation bond of the
same real yield to maturity, or indeed earns any income at all on the higher coupon payments, the
difference is much less. Thus, the importance of this 11.7 basis points is open to argument.

Cumulative
Income
12%

Inflation
Rate
4%

10%
3%
8%

6%

2%
CIPS
Cumulative Income

4%

TIPS
Cumulative Income
1%

2%
Holding Period from t-1 to t23
0%

0%
-15

-12

-9

-6

-3

12

15

18

21

24

Time (months from first coupon payment)

Figure 3: TIPS and CIPS perform similarly if inflation is stable (and especially if it is low and stable).

B. Rising Inflation:
The situation grows more intriguing as we consider a situation in which inflation
is not stable but rather is accelerating. Figure 4 illustrates a situation in which inflation
begins the period at 1% (15 months before the first CIPS coupon is paid), and rises at
one-twelfth of 1% per month throughout the window of comparison. Over the holding
period, inflation rises at a compound annual rate of 3.256%.
Because both structures look backwards to some degree, neither bond entirely
keeps pace with inflation. However, the TIPS bond performs much better, because it is
only looking back three months while the CIPS bond is looking back further. The
compounded annual return for the TIPS structure is 4.988%, for a real return of 1.732%.
Note that the difference between the realized real return and the stated 2% real yield is

very close to three months acceleration in inflation in this scenario: approximately


0.25%.
CIPS, on the other hand, endure a comparatively dismal return of 4.432%, only a
1.176% real return. This is because they are looking back further, and therefore
effectively substitute some of last years inflation for some of the inflation in the second
year of the holding period (refer again to Figure 2). If, at the time of pricing, inflation
curves are accurately forecasting the rising-inflation environment, then to make these two
structures represent similar value the CIPS bond will have to carry a coupon (or be priced
to yield) in the neighborhood of 2.55% rather than 2% to compensate for the (known)
disadvantage stemming from the lookback. The bond will then probably be sold to
investors as having a better spread than the other structure.
Cumulative
Income
12%

Inflation
Rate
4%

10%
3%
8%

6%

2%
CIPS
Cumulative Income

4%

TIPS
Cumulative Income
1%

2%
Holding Period from t-1 to t23
0%

0%
-15

-12

-9

-6

-3

12

15

18

21

Time (months from first coupon payment)

Figure 4: TIPS outperform CIPS if inflation is rising (especially if it is high and rising).

24

In fact, this happened in practice. In early 2004, the CIPS structure boomed in
popularity over the TIPS structure. The CIPS product looked much more attractively
priced, because t-3/t-15 was running comfortably below 2% while forward inflation on the
inflation derivatives curve was priced at more than 3%. The CIPS were sold with spreads
that were considerably wider than comparable TIPS-style bonds. Later in the year,
interest began to wane as year-on-year inflation rose over 3.5%, well above what was
implied by the curve, and we instead witnessed the phenomenon illustrated in the next
section.

C: Declining Inflation (Disinflation):


Figure X illustrates a situation in which inflation begins the period at 4.25% (15
months before the first CIPS coupon is paid), and declines at one-twelfth of 1% per
month throughout the window of comparison. Over the holding period, aggregate
inflation is at a compound annual rate of 2.061%.
Both bonds now benefit from the lags in their structures, with the greater lag in
the CIPS bond bringing it out on top. CIPS clock a 4.677% return (2.616% real), while
TIPS only return 4.314% (2.253% real). Again, note that TIPS outperform the stated real
yield by the same amount by which they underperformed previously: by about three
months change in the inflation rate.
CIPS superior return occurs because the longer look-back effectively means they
are substituting some of last years high inflation for some of the inflation in the second
year of the holding period (again, refer to Figure 2). If, at the time of pricing, inflation
curves are accurately forecasting the declining-inflation environment, then to make these

two structures represent similar value the CIPS bond will carry a coupon in the
neighborhood of 1.70% rather than 2% to compensate for the (known) advantage
resulting from the lookback.
Cumulative
Income
12%

Inflation
Rate
4.00%

10%
3.00%
8%

6%

2.00%
CIPS
Cumulative Income

4%
TIPS
Cumulative Income

1.00%

2%
Holding Period from t-1 to t23
0%

0.00%
-15

-12

-9

-6

-3

12

15

18

21

24

Time (months from first coupon payment)

Figure 5: CIPS bonds outperform in disinflationary periods, especially when inflation is generally
low.

When this situation actually occurred, in late 2004 and early 2005, CIPS
structuring slowed down somewhat, and some investors were confused that suddenly the
spreads of CIPS to the sovereign TIPS curve were really poor, rather than really good.
Not a few of them accused Wall Street dealers of taking more of the pie for themselves,
but to be fair the salespeople at the time were often as confused as the investors they were
selling to.8

Ever adaptable, institutional salespeople began to sell CIPS on the basis of the attractive first coupon,
which benefited from the higher known inflation in the historical period.

So, generally speaking:

TIPS give inflation exposure more well-tailored to the holding period


than do CIPS.

In rising-inflation environments, TIPS returns tend to exceed CIPS


returns (assuming the same real coupon).

In declining-inflation environments, CIPS returns tend to exceed TIPS


returns (assuming the same real coupons.

Now, lets turn to some of the more complex differences that make comparing
these two structures inherently difficult.

The Value of a Floor on Coupons


One of the key differences between the TIPS structure and the CIPS structure is in
the nature of the protection against outright declines in prices. There are two forms of this
immunization: protection against a periodic decline in prices, and protection against
deflation over the entire holding period.
TIPS protection is of the latter sort only. As noted previously, the principal
redemption value (see formula (2)) is guaranteed to never be less than par, even if the
reference CPI on the maturity date is lower than the bonds Base CPI. Thus, if prices fall
on balance over the notes life, the investor still recoups the nominal value of his original
investment, which is now worth more in real terms.
However, note that this is not an incremental advantage to TIPS: most bonds, in
fact, pay back par at maturity whether there is inflation or deflation. Indeed, if a particular
seasoned TIPS issue has already accreted some additional principal, it is now exposed to

some amount of deflation since the extra principal is not protected. This treatment is of
course consistent with the notion that the buyer of a TIPS bond earns a real yield, since
such a concept implies that the investor loses nominal value in deflationary times just as
it implied that the investor gains value in inflationary times. But it is not an advantage of
TIPS.
CIPS, on the other hand, provide the same terminal protection since the par
amount remains the par amount no matter whether deflation is realized or not. For the
purposes of this paper, that is fortuitous since the analysis of the value of the terminal
floor on TIPS is one of the unsettled arguments in the market today. However, CIPS
also provide protection against the possibility of deflation during any coupon period.
They do not do this explicitly, but implicitly: it is an absurdity to think that the purchaser
of a bond would ever send money back to the issuer on the coupon date; therefore, if a
CIPS-style bond pays 2%+CPI, it effectively has a floor at -2% inflation since the coupon
cannot be negative.
And this floor can have value, especially in the current environment of tame core
inflation. Although headline inflation in the United States has not been negative on a 12month basis since the 1950s, the oil bust in the mid-1980s took the Y/Y CPI down to
about 1.1% in 1986, while core inflation was 3.8%. A sharp decline in oil prices or food
prices today, with core inflation below 3%, could very easily push annual inflation
negative. Other major economies have experienced deflation in fairly recent times. In
short, this is not a risk that the issuer, who is short such an implied floor (or, more likely,
the swap dealer who has taken the issuer out of that risk) can afford to ignore.

The value of the floor on the CIPS coupons can be established several ways, but
the pros and cons of different option models when it comes to putting a price on an
inflation floor is a topic beyond the scope of this paper. Suffice to say that it is a nontrivial problem and very unlike the pricing of a LIBOR floor since inflation can go
negative while LIBOR cannot.

This paper is a work-in-process. Remaining topic headings may include The


Value of Different Patterns of Inflation Compensation and Establishing Value in the
Comparison of TIPS to CIPS, and perhaps others. Its hard to tell.

***give some sample pricing and rule of thumb? Or just say that the
compensation has ranged from near 0bps to 5-7bps per year over the last several years?

However, the reasonableness of the examples used here have been confirmed
empirically by querying the inflation-linked broker market, where such structures are
quoted and traded.
The Value of Different Patters of Inflation Compensation
(show mathdifficult to evaluate)

Evaluating Value in the Comparison of TIPS to CIPS

So, if a particular CIPS is spread 40bps over the same-maturity TIPS, while the
same companys regular debt trades 30bps over Treasuries, is that good value or poor
value? The answer is that without a proper inflation-linked infrastructure for valuing the
cash flows on an apples-to-apples basis, it is difficult to evaluate such a proposition. But
we can make some back-of-the-envelope comparisons on the basis of the observations
above.
The main difference in value comes, as noted above, from the different periods
the two bonds cover. In a rising-inflation environment, TIPS tend to perform better, while
CIPS tend to do better when inflation has been high and is receding. As noted, this is less
due to the fundamental superiority or inferiority of one structure compared to another and

more due to differences in relative value due to way those particular structures interact
with the particular inflation environment. How can an investor adjust for this difference
in structures?
Refer to Figure 2 once again. Since the CIPS bond has a longer lookback and less
exposure to inflation near maturity, the adjustment to a TIPS structure that we need to
make is to add back already-realized inflation and subtract future inflation to the bonds
yield. If expected future inflation is higher than previous inflation, then this will result in
a lower TIPS-adjusted yield to compare, and the bond is properly considered to be
more expensive than it appears on a straight comparison of the two yields. If expected
future inflation is lower than previous inflation, then this adjustment will result in a
higher yield to compare, and the bond will be cheaper than it looks.

*structure
* credit
*floor

The fundamental differences between the structures of the two bond types can be
summarized thus: they have different payment frequencies, different patterns of inflation
accretion, different lengths of the inflation lookback, and different types of inflation

floors.9 As a consequence, they have significantly different exposures to future inflation.


It is, therefore, inaccurate and inappropriate to compare two bonds of these different
types with a simple, unadjusted spread. This is, in short, comparing iApples to iOranges.

References: Global Inflation-Linked Products, A Users Guide, Barclays Capital

When one particular CIPS bond is compared to a particular TIPS bond, they are also very likely to have
different maturities. Because both instruments pay on the basis of non-seasonally adjusted inflation, even
modest differences in final maturity can have non-negligible impacts on relative value. However, the
analysis of the impact of seasonality on the relative value of inflation-linked securities is a topic beyond the
scope of this paper.