Treasury Inflation Protected Securities

Treasury Inflation Protected Securities (or TIPS) are bonds that are issued by the U.S. Treasury and specifically designed to protect against rising inflation. 

Inflation is particularly concerning for bondholders since it can erode future purchasing power.  The principal of a Treasury Inflation Protected Security increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When this type of fixed income investment 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.

The semiannual interest payments received by the investor are determined by multiplying the inflation-adjusted principal value by one-half of the stated coupon payment.  The coupon rate remains the same for the life of the security, but the coupon payment will change based on the changing principal value.

At maturity, it is possible that the inflation-adjusted principal will be less than the initial par value (because of deflation).  However, the U.S. Treasury has structured TIPS so that the asset is redeemed at the greater of the inflation-adjusted principal or the initial par value.

It is best to illustrate how TIPS work with an example:

Assume a Treasury Inflation Protected Security has a 4.5% coupon rate and the annual inflation rate is 4%.  An investor purchases on January 1, $100,000 of par value in the issue.  The semiannual inflation rate is 2% (4% ÷ 2 periods in a year).

The inflation-adjusted principal at the end of the six-month period is calculated by multiplying the original par value by the semiannual inflation rate as follows:  $100,000 x 1.02 = $102,000.

The new inflation-adjusted principal is then used as the basis for computing the coupon interest rate for the first six months as follows:  The six-month coupon rate is 4.5% ÷ 2 = 2.25% giving us a coupon payment of $2,295 ($102,000 x 2.25%)

Now, if the semiannual inflation rate for the next six months is 1.5%, the inflation-adjusted principal will now be $103,530 ($102,000 x 1.015) and the coupon payment would then be $2,329.43 ($103,350 x 2.25%).

TIPS provide protection from both interest rate risk and purchasing power risk, making them an attractive security for those investors concerned about rising inflation and devaluation due to loss of purchasing power.

As far as investing in these securities, I typically recommend a low-cost exchange-traded fund (ETF) to gain exposure to this asset class.  This way you have a diversified portfolio of TIPS with a large variation of maturities that is managed by specialists in these types of securities.  Institutional traders will trade TIPS at various occasions in the market in order to enhance returns and balance risk.  

Contact Westview with any questions or to learn more.