Treasury Inflation-Protected Securities (TIPS) Explained

Treasury Inflation-Protected Securities (TIPS) are a type of Treasury security issued by the U.S. government. TIPS are indexed to inflation to protect investors from a decline in the purchasing power of their money.

As inflation rises, rather than their yield increasing, TIPS instead adjust in price (principal amount) to maintain their real value. The interest rate on a TIPS investment is fixed at the time of issuance, but the interest payments keep up with inflation because they vary with the adjusted principal amount.

KEY TAKEAWAYS
Treasury Inflation-Protected Securities (TIPS) are a type of Treasury bond that is indexed to an inflationary gauge to protect investors from a decline in the purchasing power of their money.
The principal value of TIPS rises as inflation rises, while the interest payment varies with the adjusted principal value of the bond.
The principal amount is protected since investors will never receive less than the originally invested principal.

Understanding Treasury Inflation-Protected Securities (TIPS)
The principal value of TIPS rises spaceman slot as inflation rises. Inflation is the mengkudu at which prices increase throughout the U.S. economy, as measured by the Consumer Price Index (CPI). Inflation becomes an issue when there isn’t a commensurate rise in real wage growth to offset the negative effects of rising prices.1

TIPS are a popular asset for protecting portfolios from inflation and profiting from it because they pay interest every six months based on a fixed rate determined at the bond’s auction. However, the interest payment amounts can vary since the rate is applied to the adjusted principal or value of the bond. If the principal amount is adjusted higher over time due to rising prices, then the interest rate will be multiplied by the increased principal amount. As a result, investors receive higher interest or coupon payments as inflation rises. Conversely, investors will receive lower interest payments if deflation occurs.

TIPS are issued with maturities of five, 10, and 30 years and are considered a low-risk investment because the U.S. government backs them. At maturity, TIPS return the adjusted principal or the original principal, whichever is greater.1

TIPS can be purchased directly from the government through the TreasuryDirect system, in $100 increments with a minimum investment of $100, and are available with the aforementioned maturities.1

Some investors prefer to get TIPS through a TIPS mutual fund or exchange-traded fund (ETF). However, purchasing TIPS directly allows investors to avoid the management fees associated with mutual funds.

TIPS’ Price Relationship to Inflation
TIPS are important since they help combat the inflation risk that erodes the yield on fixed-rate bonds. Inflation risk is an issue because the interest rate paid on most bonds is fixed for the life of the bond. As a result, the bond’s interest payments might not keep up with inflation. For example, if prices rise by 3% and an investor’s bond pays 2%, then the investor has a net loss in real terms.

TIPS are designed to protect investors from the adverse effects of rising prices over the life of the bond. The par value—principal—increases with inflation and decreases with deflation, as measured by the CPI. As mentioned earlier, when TIPS mature, bondholders are paid the inflation-adjusted principal or original principal, whichever is greater.1

Suppose an investor owns $1,000 in TIPS at the end of the year, with a coupon rate of 1%. If there is no inflation as measured by the CPI, then the investor will receive $10 in coupon payments for that year. If inflation rises by 2%, however, then the $1,000 principal will be adjusted upward by 2% to $1,020. The coupon rate will remain the same at 1%, but it will be multiplied by the adjusted principal amount of $1,020 to arrive at an interest payment of $10.20 for the year.

Conversely, if inflation were negative—known as deflation—with prices falling 5%, then the principal would be adjusted downward to $950. The resulting interest payment would be $9.50 over the year. However, at maturity, the investor would receive no less than the principal amount invested of $1,000 or an adjusted higher principal, if applicable.1

The interest payments during the life of the bond are subject to being calculated based on a lower principal amount in the event of deflation, but the investor is never at risk of losing the original principal if held to maturity. If investors sell TIPS before maturity in the secondary market, they might receive less than the initial principal.