What are TIPS?

In 1997, the U.S. Treasury introduced notes and bonds in a new form to help investors manage inflation risk. Known as Treasury Inflation-Indexed Securities (TIIS) or Treasury Inflation Protected Securities (TIPS), the principal amount of these securities is adjusted periodically for inflation.

Using the Consumer Price Index (CPI) as a guide, the value of the TIPS’ principal is adjusted to reflect the effects of inflation. A fixed interest rate is paid semi-annually on the adjusted amount. At maturity, if inflation has increased the value of the principal, the investor receives the higher value. If deflation has decreased the value, the investor still receives the original face amount of the security.

So, unlike the circumstance with traditional, nominal Treasury bonds, inflation will cause TIPS to earn additional interest based on the adjusted principal amount. On the other hand, deflation will cause a slower increase in TIPS value or result in no increase in value at all.

Because of the built-in inflation protection, these securities usually offer lower coupon rates than nominal Treasuries of similar maturities without the feature.

For detailed information on other Treasury securities, including Treasury bills, notes and bonds, visit InvestingInBonds.com. Historical CPI data is available on InterNotes.com.

How TIPS work: An example

Let's say you invested $1,000 in January on a new, 10-year inflation-indexed note paying 3 percent interest. At mid-year, the Consumer Price Index indicates that inflation has been 1 percent during the first six months. Your principal is adjusted upward to $1,010 and your interest payment (one-half of 3 percent) is based on that figure. So, your first semiannual interest payment is $15.15. At the end of the year, the index indicates that inflation was 3 percent, which brings the value of your principal to $1,030. Your second interest payment is $15.45 (or $1,030 times 3 percent, divided by 2).

TIPS offer a number of potential benefits to investors:

• High credit quality. Treasury inflation-indexed securities are direct obligations of the United States government and are backed by the full faith and credit of the federal government.
• The principal is protected against inflation. Since the principal is indexed to the Consumer Price Index and grows with inflation, the investor is guaranteed that the real purchasing power of the principal will keep pace with the rate of inflation.
• Interest is protected from inflation. The investor will receive semiannual interest payments, based on a fixed semiannual interest rate applied to the inflation-adjusted principal, so that the investor is guaranteed a real rate of return above inflation.

One risk is that deflation could cause the principal to decline and the securities could under perform traditional Treasury securities.

Treasuries can be bought and sold through an investment professional, a commercial bank or an online broker. Some individuals prefer to buy new issues directly from the government at auction through its TreasuryDirect^sm program.

You can sell a Treasury held in a TreasuryDirect account, through a Treasury program called Sell Direct^®.

For more information on TreasuryDirect, visit the Bureau of Public Debt's Web site.

TIPS are available for purchase as individual securities and in mutual funds, typically in minimum denominations of $1,000 and multiples of thereof.

Like other Treasury notes and bonds, TIPS are exempt from state and local income taxes, but subject to federal income tax.

As for federal taxes, generally, the interest payments on TIPS are taxable when received, which is consistent with the tax treatment of other Treasury securities. Also, the inflation adjustments to the principal are taxable in the year in which such adjustments occur even though you won't receive your inflation-adjusted principal until the security matures.

For more information on the tax treatment of TIPS, visit the Treasury’s Web page on the subject.

Source: Bond Market Association