Treasury Inflation-Protected Securities (TIPS)
What are Treasury inflation-protected securities?
Treasury Inflation-Protected Securities (TIPS) are investments that are indexed to protect against inflation. These bonds are backed by the U.S. government and are considered extremely low-risk investments. Their par value, or face value, rises with inflation as measured by the consumer price index.
Many fixed income investments come with inflation risk. As inflation increases, the value of the investment’s interest decreases. TIPS offer an effective way for income investors to eliminate inflation risk.
The fixed interest rate on TIPS is paid every six months, and the inflation adjustment is made on a semiannual basis. The inflation adjustment is applied to the bond’s face value instead of the interest rate. This method protects the bond’s interest payment from inflation and also protects the bond’s face value.
The yearly profits from TIPS are considered taxable income by the IRS, even if the TIPS aren’t redeemed. Given the tax implications of TIPS investments, many investors purchase TIPS through mutual funds or deferred retirement accounts.
Compared to other government and corporate securities, TIPS offer lower interest rates. While the bonds offer inflation protection, their usefulness decreases in periods when inflation is low or during periods of deflation.
TIPS are issued with 5-, 10- and 30-year maturities. They can be purchased directly from the government via TreasuryDirect (part of the U.S. Department of Treasury), a bank or a broker.
TIPS can be redeemed before or at their maturity date. TreasuryDirect requires a minimum 45-day period of ownership before redemption. While purchasing TIPS directly from TreasuryDirect is the least expensive, although the can be bought through mutual funds.
Treasury Inflation-Protected Securities (TIPS) example
For example, if you buy a $10,000 bond with an interest rate of 2 percent but inflation equals 3 percent that year, the face value of the bond will be increased by $300 to $10,300 and the 2 percent interest rate will be applied to the new face value.
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