Treasury Inflation -Protected securities (TIPS):
Treasury Inflation-Protected securities, or TIPS, provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater. TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal; so like the principal, interest payments rise with inflation and fall with deflation. TIPS were designed such that it protects investors from the negative effects of Inflation.
TIPS are considered an extremely low-risk investment since they are backed by the U.S government and because the par value rises with inflation, as measured by Consumer price Index, while interest rate remains fixed. TIPS are issued in terms of 5, 10, and 20 year maturities and these can be purchased directly from the government through the Treasury Direct system, in $100 increments with a minimum investment of $100.
TIPS Inflation Index ratios can be used to calculate the inflation adjustment to principal on previously issued TIPS.TIPS can be held until maturity or sold before maturity. Interest income from TIPS is subject to federal income tax, but they are exempt from state and local income taxes.
EXAMPLE OF TREASURY INFLATION PROTECTED SECURITIES:
- Assume a person X, owns $100 in TIPS, with a coupon rate of 10%. Now three things can happen as the time goes by..,
- No Inflation
- Positive Inflation
- Negative Inflation
- If there is no Inflation as measured by the CPI, the investor will receive $10 over the year in coupon payments. If inflation rises by 5%, however, the $100 principal will be adjusted upward by 5%to 105. The coupon rate will still be the same at 5%, but it will be multiplied by the new principal amount of 105 to get an interest payment of $10.5. On the other hand if inflation was negative, as in deflation with prices measured by the CPI falling 5%, the principal will be adjusted downward to $95. The resulting interest payment would be $9.50 over the year.
- The advantage of TIPS is that, at maturity the investor would receive the principal equal to either the original principal of $100 or an adjusted higher principal, if applicable. The interest payments during the life of the bond are subject to being calculated from a lower principal, but the investor is never at risk of losing the total principal of TIPS if held to maturity. The investor can sell TIPS for less than the initial principal in the secondary market, however before maturity.
Like all marketable securities TIPS are backed by the full faith and credit of the United states.