Treasury Inflation Protected Securities (TIPS)

This is the first in a series of articles on Treasury Inflation Protected Securities.

Treasury Inflation-Protected Securities, often called TIPS, are government issued securities whose value is linked to the inflation rate. Like Treasury bills, bonds and notes, TIPS are backed by the full faith and credit of the United States government. This make TIPS an ideal investment for those concerned about safety when investing. Treasuries are considered to be the safest investment in the world. TIPS are liquid securities that can be bought and then resold at any time on the open market or directly to the Treasury Department.

TIPS are very different than standard bonds. TIPS pay a stated interest rate like a typical bond (fixed interest rate); however, the principal is adjusted every six months based on the changes in the Consumer Price Index (CPI). If inflation rises the principal of the bond increases, if deflation occurs your principal decreases. Just like all government securities you can never receive less than par (100) if you hold the TIPS to maturity. One of the best features of TIPS is you receive the inflation adjusted principal or the original principal, whichever is greater when the bonds mature.

TIPS pay a fixed rate of interest. However, the interest is applied to the inflation-adjusted principal of the security. If inflation as measured by the CPI increase over the course of ownership of the TIPS every interest payment would rise. If deflation occurs then the interest payment would decline. The amount of interest paid is calculated by multiplying the inflation-adjusted principal (regardless of whether it is greater or less than the original face value) by one-half the fixed annual interest rate (TIPS pay interest every six months).

Unlike typical bonds where you pay a broker a fee, you can buy TIPS direct from the US Treasury. This means 100 percent of your investment goes to work from day one. It is not unusual to suffer a 25-50 basis point drop in yield when purchasing a bond from a broker (the commission you pay reduces the yield, something investors often fail to take into account). And, if you are purchasing a small amount of bonds, the "real" yield on your investment can be reduced by one or more percentage points. The ability to buy TIPS direct from the Treasury is certainly a feature that makes the bonds more attractive.