Inflation-protected securities (TIPS) are a type of U.S. Treasury bond designed to help investors protect their money from inflation. They are indexed to inflation and backed by the U.S. government, providing investors with a fixed interest rate while adjusting their nominal value according to the rate of inflation.
How do inflation-protected securities work?
Like regular Treasury bonds, TIPS pay interest twice a year based on a fixed rate. They differ from regular bonds in that their nominal value is adjusted up or down based on inflation as measured by the Consumer Price Index (CPI). The rate of return that investors receive reflects the adjusted nominal value.
An example of inflation-protected securities
The best way to understand how TIPS work is through an example. TIPS pay interest every six months, but for simplicity, let’s look at how the bond’s value changes each year of the calendar.
Let’s assume the Treasury issues an inflation-protected security with a nominal value of $1,000 and a bond rate of 3%. In the first year, the investor receives $30 in two semiannual payments. That year, the Consumer Price Index increases by 4%. As a result, the nominal value is adjusted to $1,040.
In the second year, the investor receives the same 3% bond rate, but this time it is based on the new adjusted nominal value of $1,040. The result: instead of receiving a $30 interest payment, the investor gets $31.20 (0.03 times $1,040). In the third year, inflation drops to 2%. The nominal value increases from $1,040 to $1,060.80, and the investor receives $31.82 in interest.
This process continues until the bond matures. In this way, TIPS payments consist of two parts: the increase in the Consumer Price Index and the “real yield,” which is the yield above inflation.
When the bonds mature, investors receive either the higher adjusted nominal value or their original investment, whichever is greater. As a result, investors cannot receive less than the nominal value of the bond, even in the rare event of deflation (a drop in prices).
Price volatility risks
Investing in inflation-protected securities may seem very attractive at first glance, but investors should consider three issues:
- During the life of TIPS, capital declines during periods of deflation or a decrease in the Consumer Price Index.
- The increase in the bond’s value leads to tax payments each year, which not only affects the inflation protection element but also creates additional tax liability. For this reason, individual inflation-protected bonds are more suitable for tax-advantaged accounts.
- Although TIPS carry no credit risk – meaning there is no risk of default by the issuer: the U.S. government – their prices fluctuate between issuance and maturity dates.
Inflation-protected securities are also very sensitive to changes in prevailing interest rates. As a result, you can lose money if you sell a TIPS bond before maturity. In this case, capital losses may exceed the benefit of inflation protection. However, if you intend to hold the bond until maturity, there should be no issue.
Capital volatility is more likely to be a problem if you own a mutual fund or an exchange-traded fund (ETF) that invests in inflation-protected securities. In this case, rising interest rates may lead to a significant drop in the fund’s price value. Unlike an individual bond, mutual funds do not have specific maturity dates, so you do not have a guarantee of getting back your full capital value.
Questions
Frequently Asked Questions (FAQs)
Where can I buy Treasury Inflation-Protected Securities (TIPS)?
You can buy Treasury Inflation-Protected Securities from the U.S. Department of the Treasury through TreasuryDirect if you set up an online account. Additionally, you can also purchase them through a bank or broker.
How is the interest on Treasury Inflation-Protected Securities calculated?
The interest on Treasury Inflation-Protected Securities is calculated based on the rate of inflation every six months. To calculate the current value of the security you already own, you can find your issuance period on the chart in TreasuryDirect. Click on the link for your period, then find your issuance date in the table on the next page. Multiply the original principal by the indexed rate listed to find the current value.
Source: https://www.thebalancemoney.com/how-do-tips-work-417128
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