I expect the long-term price of TIP to average somewhere between $95 and $110. It is not a coincidence or a streak of bad luck that TIP has mostly been trading within that range since its inception in 2003.
Those thinking TIP's price will continue to appreciate as it has from late 2008 to present will be sorely disappointed someday. I don't know how low real interest rates can fall, but there is a limit somewhere. 5-year TIPS are already priced to lose purchasing power. If nothing else, when rates are so low that 5-year TIPS are priced to lose serious money perhaps even bedpan hoarding will seem like a good idea by comparison.
"All that plus a gain in principal. Great."
I still don't think I am being clear here. You don't get all that plus a gain in principal. The inflationary gain in principal is being distributed to you. That's what makes the distributions high.
TIP's price is tied to interest rates. The reason TIP's price is currently high is because interest rates on TIPS bonds are so low. As of yesterday, the interest rate on 5-year TIPS was -0.46%. That is an awful interest rate. You are virtually guaranteed to lose purchasing power with that bond. The only possible way you won't is if severe deflation kicks in and the deflation protection of TIPS comes into play.
TIP's distributions are tied to inflation rates. You don't necessarily get a gain in principal if inflation heats up. All you know for sure is that the distributions of the fund will increase. Why might TIP's price not rise? The taxation of TIPS might make them less desirable at higher inflation rates.
For example, if TIP pays out 20% because inflation is 20%, then many people (myself included) would be feeling serious pain. First, I would be pushed into a higher tax bracket. Second, there would be a lot to tax. After taxes, I'd net only about 13%. Earning 13% when inflation is 20% might be better than some alternatives but it isn't exactly a joyride.
We weren't talking about individual TIPS though. We were talking about TIP.
The following was stated (by someone else):
"NO, the price of the TIP will increase 20%..."
I disagreed. I said:
"The price of TIP will NOT increase 20% if inflation hits 20%. TIP tends to pay out all inflationary gains and interest as distributions. That's why the price of TIP does not generally rise over time."
You told me I was wrong. I wasn't.
One more thought.
The original question asked if TIP pays 20% compounded if inflation hits 20%. It can but it is up to you to decide.
One way to make sure that it does would be to buy TIP within a retirement account and use an automatic dividend reinvestment plan to reinvest the distributions back into TIP.
I once did that. I recently stopped though. I did not like the extremely low yields at the short end of the yield curve (and TIP owns a lot of them). I decided to fill my IRA instead with one long-term TIPS bond. The interest rate was much better and I won't need to touch that money for 20+ years anyway.
I will be buying more individual TIPS bonds over the years with the proceeds that bond generates.
That's what I am doing anyway. I can't say that it is an optimal solution if real interest rates rise, but at least I know that I have locked in a reasonable interest rate over the next 29 years.
"NO, the price of the TIP will increase 20% and the dividend will be calculated against the increased price. That is not a 20% divi increase. Read 'Exploring TIPs'."
You are mistaken.
The price of TIP will NOT increase 20% if inflation hits 20%. TIP tends to pay out all inflationary gains and interest as distributions. That's why the price of TIP does not generally rise over time.
TIP's price only tends to rise if people bid up the underlying bonds above and beyond the inflation that is driving them higher. In other words, TIP's price only tends to rise if real interest rates fall as people flood into TIPS.
If core inflation is 20% higher,then the principal will be 20% higher,as dividend is fixed but the principal that is the base to calculate the dividend amount, therefore the div will increase by 20%.Let say principal is 100$ and coupon is 3% annually then you will get 3 dollars div,then if core inflation hits 20%,the base to calculate your next dividend will be 120$,as coupon payments are still 3% you will get 3.6 dollars,that is 20% higher than the previous dividend,3X1.2=3.6
"Do tips pay 20% compounded?"
As a side note, I really don't like Yahoo. You go to all the time to create a detailed post and when you try to post the message Yahoo just eats it. No warning that it will delete what you type. Not a care that it ticks off their customers. It just considers what you write as SPAM I guess and decides your comments are worthless.
I had a longer more detailed answer but I give up. Sorry!