Jeff, in response to yesterday's conversation I set up a spreadsheet showing the effects of the coupon yield and inflation on taxable income.

TIPS are adjusted for inflation. The principal of the bond is multiplied by the inflation rate. This adjustment is then added to the principal. The adjustment is taxable each year even though it is not added to cash flow. (It's similar to the interest from a CD which is taxed every year even though you don't get it until the CD matures.) This is sometimes called "phantom income" because it's taxable but not added to cash flow.

The interest income is the coupon rate multiplied by the principal. Since the principal grows at the rate of inflation the coupon interest grows every year even though the coupon percent stays the same.

If the coupon rate is low and inflation is high the phantom income can be higher than the coupon interest income. The worst situation is a low coupon rate and a high inflation rate. "Total" includes the growing principal and taxable income minus tax.

Year	Principal	Coupon	Inflation	Coupon income	Phantom Income	Taxable Income	Tax rate	Tax	Cash flow	Total
1	$1,000.00	0.625%	2.00%	        $6.25	        $20.00	        $26.25	        25%	        $6.56	-$0.31	        $1,019.69
2	$1,020.00	0.625%	2.00%	        $6.38	        $20.40	        $26.78	        25%	        $6.69	-$0.32	        $1,040.08
3	$1,040.40	0.625%	2.00%	        $6.50	        $20.81	        $27.31	        25%	        $6.83	-$0.33	        $1,060.88
										
										
Year	Principal	Coupon	Inflation	Coupon income	Phantom Income	Taxable Income	Tax rate	Tax	Cash flow	Total
1	$1,000.00	0.625%	10.00%	        $6.25	        $100.00	        $106.25	        25%	       $26.56	-$20.31	        $1,079.69
2	$1,100.00	0.625%	10.00%	        $6.88	        $110.00	        $116.88	        25%	       $29.22	-$22.34	        $1,187.66
3	$1,210.00	0.625%	10.00%	        $7.56	        $121.00	        $128.56	        25%	       $32.14	-$24.58	        $1,306.42
										
Year	Principal	Coupon	Inflation	Coupon income	Phantom Income	Taxable Income	Tax rate	Tax	Cash flow	Total
1	1000	        2.650%	2.00%	        $26.50	        $20.00	        $46.50	        25%	        $11.63	$14.88	        $1,034.88
2	1020	        2.650%	2.00%	        $27.03	        $20.40	        $47.43	        25%	        $11.86	$15.17	        $1,055.57
3	1040.4	        2.650%	2.00%	        $27.57	        $20.81	        $48.38	        25%	        $12.09	$15.48	        $1,076.68
										
										
Year	Principal	Coupon	Inflation	Coupon income	Phantom Income	Taxable Income	Tax rate	Tax	Cash flow	Total
1	1000	        2.650%	10.00%	        $26.50	        $100.00	        $126.50	        25%	        $31.63	-$5.13	       $1,094.88
2	1100	        2.650%	10.00%	        $29.15	        $110.00	        $139.15	        25%	        $34.79	-$5.64	       $1,204.36
3	1210	        2.650%	10.00%	        $32.07	        $121.00	        $153.07	        25%	        $38.27	-$6.20	       $1,324.80

Like any other bond, a TIPS may be held to maturity to receive the full (inflated) principal. Or it may be sold on the secondary market before maturity. If prevailing interest rates fall the TIPS will sell for more. If prevailing interest rates rise the TIPS will sell for less. The longer the duration the larger the swing.

Generally, the Federal Reserve controls only the overnight fed funds rate and not the long-term yields which are set by the bond market. However, the Fed can and has bought massive amounts of long-term Treasuries, mortgage bonds and even corporate bonds in the past and they could again.

https://fred.stlouisfed.org/series/WALCL

This chart shows QE during the 2008 financial crisis and the Covid crisis. But there was also a significant amount of buying in 2012 - 2014 (QE3) to stimulate the economy which was still slow during the "Great Recession." This shows that the Fed might be influenced to suppress long-term interest rates in case of recession -- or even if the White House declares a bogus "emergency" as Trump has done several times already.

On the other hand, inflation is a real threat due to massive government deficits coupled with removal of a significant part of the work force. The bond market will continue to raise long-term yields as long as this threat persists. That would depress the value of all existing bonds, including TIPS.

Wendy

Macroeconomic Trends and Risks FAQ

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