ARE TREASURY INFLATION PROTECTED SECURITIES REALLY TAX DISADVANTAGED

Abstract: In 1997, the U.S. Treasury introduced Inflation Protection (or "Indexed ") Securities, known as TIPS. Several authors have since described these securities as "tax disadvantaged" relative to conventional securities, leading to substantial debate regarding their appropriateness outside of tax-deferred accounts. In this paper, the authors develop a framework that allows them to demonstrate that the tax treatment of TIPS is trivially different from that of conventional Treasury securities. Utilizing an after-tax valuation approach, they further show that under relatively conservative projections for inflation, TIPS generally have after-tax yields comparable to, if not exceeding, conventional fixed-rate Treasury securities. Moreover, the authors find evidence that since their introduction, TIPS have outperformed matched maturity conventional Treasury securities in terms of after-tax returns. JEL classification: G0, G1, H2, H6 Key words: Treasury securities, inflation protection, income taxes, interest rates In January 1997 the U.S. Treasury followed the lead of several other countries and began auctioning inflation-indexed debt in the form of Treasury Inflation Protection (or "Indexed") Securities, commonly referred to as TIPS. Unlike the Treasury's conventional debt, these indexed debt securities have a fixed real coupon rate. Because the principal is adjusted (semiannually) by the amount of inflation over the period, nominal coupon payments, equal to the product of the real coupon rate and the inflation-adjusted principal, grow with inflation. By design, these securities provide a hedge against inflation, and the real yield (equal to the real coupon rate) is essentially constant and established at issuance. The finance profession has alternated between totally ignoring the tax treatment of these new instruments on the one hand to arguing that the tax treatment of these instruments is so unique and disadvantageous to make these unworthy of taxable investors attention. A number of studies demonstrate that inflation-indexed debt can be a beneficial component of most portfolios (e.g., Bodie [1990], Campbell and Viceira [2002], and Campbell et al. [2003]). Without considering the tax treatment of these instruments these studies imply that TIPS do not have any unique tax considerations. Similarly, Jarrow and Yildirim [2003] use an arbitrage-free term structure model to fit the time series of real and nominal zero-coupon bond prices, without a tax factor. This again suggests that these authors see little in the tax treatment of TIPS to make them different from nominal Treasury securities. Others, however, emphasize the unique tax treatment placed upon TIPS as critical in interpreting these instruments. (1) Essentially, taxes must be paid annually on accrued increase in principal caused by inflation, even when this is an unrealized gain. Therefore, the owner is required to pay taxes on "phantom income" that is not actually received until maturity or upon sale of the bond. This tax treatment has led several leading authorities in the field to characterize TIPS as "tax disadvantaged." See, for example, Fabozzi [2000], Van Horne [2001], and Sundaresan [2002] who all argue that TIPS have serious tax disadvantages. (2) The conclusion that TIPS are seriously tax disadvantaged has spilled into the popular press as well. For example, in a recent issue of Money magazine, Rekenthaler [2003, p.44] writes.[The tax treatment] is annoying ... therefore, TIPS are best held in a tax-deferred account." Clements [2003], in the Wall Street Journal, quotes an investment advisor, Nelson Lam, as stating, "These things [TIPS] are horribly tax inefficient." In this paper, we evaluate the notion that TIPS are tax disadvantaged. We argue that the tax treatment of TIPS needs to be compared with the tax treatment of non-inflation indexed securities, rather than in isolation. Our analysis suggests that, under fairly common assumptions, these instruments are not tax disadvantaged relative to conventional Treasury debt. …