Basics of Treasury Inflation Protected Securities Work (TIPS)
Treasury Inflation-Protected Securities (TIPS) are a form of U.S. Treasury bond designed to help investors protect against inflation. These bonds are indexed to inflation, have U.S. government backing, and pay investors a fixed interest rate as the bond's par value adjusts with the inflation rate.
How TIPS Work
Like regular Treasury bonds, TIPS pay interest twice a year based on a fixed rate. TIPS differ from ordinary Treasuries in that the principal value of TIPS adjusts up and down based on inflation as measured by the Consumer Price Index (CPI). The rate of return investors receive reflects the adjusted principal.
The best way to understand how TIPS work is by example. TIPS pay interest semiannually, but for the purposes of simplicity, the following looks at how the value of the bond changes in each calendar year.
Say the Treasury issues an inflation-protected security with a $1,000 face value and a 3 percent coupon. In the first year, the investor receives $30 in two semiannual payments. That year, the CPI increases by 4 percent. As a result, the face value adjusts upward to $1,040.
In Year 2, the investor receives the same 3 percent coupon but this time it’s based on the new, adjusted face value of $1,040. The result: instead of receiving an interest payment of $30, the investor receives interest of $31.20 (.03 times $1,040). In Year 3, inflation drops to 2 percent. The face value rises from $1,040 to $1060.80, and the investor receives interest of $31.82.
This process continues until the bond matures. In this way, the TIPS’ payout consists of two parts: the increase in CPI and the “real yield,” that is, the yield above inflation.
Once the bonds mature, investors receive either the adjusted, higher principal or their original investment, whichever is greater. As a result, investors cannot ever receive less than the face value of the bond, even in the rare case of deflation (falling prices).
Price Fluctuation Risks
Investing in TIPS may seem very compelling at first glance, but investors should consider three issues:
- During the life of a TIPS bond, its principal declines in periods of deflation, or falling CPI.
- The increase in face value of the bond triggers taxes each year, which not only eats into the element of inflation protection but also creates additional tax work. For this reason, individual TIPS bonds make more sense for a nontaxable account.
- While TIPS don’t carry credit risk—the risk of default by their issuer: the U.S. government—their prices do fluctuate between their issue date and maturity date.
TIPS are also highly sensitive to changes in prevailing interest rates. As a result, you could lose money if you sell a TIPS prior to its maturity. In this case, the loss of principal may far outweigh the benefit of inflation protection. If you intend to hold the bond until maturity, however, that isn’t an issue.
Principal fluctuations are much more likely to be an issue if you own a mutual fund or exchange-traded fund (ETF) that invests in TIPS. In this case, rising interest rates will lead to a substantial decline in the value of the fund’s share price. Unlike an individual bond, mutual funds have no set maturity date, so you have no guarantee of having the full value of your principal returned.