Treasury Inflation-Protected Securities (TIPS)
What it is:
How it works (Example):
Let's assume you purchase a 10-year TIPS for $1,000, and the annual coupon rate is 5%. Every six months, the U.S. Treasury adjusts the principal for any change in the consumer price index (CPI). The interest payment is also calculated and made on this adjusted principal amount every six months. So, if during the first six months of your investment the CPI increased by 2%, the face value of your TIP would be: $1,000 * 1.02 = $1,020 and your first semi-annual interest payment would be: $1,020 * (.05/2) = $25.50. Note that the principal is adjusted throughout the life of the bond but is paid out in one sum upon maturity.
TIPS are issued in terms of five, ten, and twenty years. The 5-year TIPS are auctioned every April and October; the 10-year TIPS are auctioned every January, April, July, and October; and the 20-year TIPS are auctioned every January and July. TIPS are available directly from the U.S. Treasury and the Commercial Book-Entry System.
Interest income from TIPS is subject to federal income tax, but is exempt from state and local income taxes. Also, in any year when TIPS principal grows, the gains are considered reportable income for federal tax purposes.
Why it Matters:
Traditionally, an investor's return on any investment is somewhat eroded, and thus risked, by the effects of inflation. TIPS allow investors to achieve a "real" rate of return and theoretically eliminate this aspect of investment risk. Thus, TIPS can sometimes provide higher returns than traditional . For example, if a traditional 10-year Treasury bond's current yield is 5% and a 10-year TIPS' current yield is 4%, the TIPS may provide a higher return than the traditional bond if the CPI increases by, say, 3% over the life of the bond. This is because 3% of the traditional Treasury bond's 5% return is eaten away by inflation, leaving a "real" return of only 2%, compared to the TIPS' 4% return, which compensated for inflation.
However, an increasing rate of inflation does not mean that TIPS will always outperform traditional bonds. The difference in yield on a traditional bond versus a TIPS may be so high that, after adjusting for inflation, it still beats the return on similar-maturity TIPS.