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What are 'Treasury Inflation Protected Securities - TIPS'

Treasury inflation protected securities (TIPS) refer to a treasury security that is indexed to inflation in order to protect investors from the negative effects of inflation. TIPS are considered an extremely low-risk investment because they are backed by the U.S. government and because the par value rises with inflation, as measured by the Consumer Price Index, while the interest rate remains fixed.

BREAKING DOWN 'Treasury Inflation Protected Securities - TIPS'

Interest on Treasury inflation protected securities (TIPS) is paid semiannually. TIPS can be purchased directly from the government through the TreasuryDirect system, in $100 increments with a minimum investment of $100, and are available with 5-, 10-, and 30-year maturities.

Because the semiannual inflation adjustments of a TIPS bond are considered taxable income by the IRS, even though investors don't see that money until they sell the bond or it reaches maturity, some investors prefer to get TIPS through a TIPS mutual fund or exchange traded fund (ETF), or to only hold them in tax-deferred retirement accounts to avoid tax complications. Purchasing TIPS directly, however, allows investors to avoid the management fees associated with mutual funds. TIPS are also valuable because they are exempt from state and local income taxes.

Example of Treasury Inflation Protected Securities Adjustments

Suppose an investor owns $1,000 in TIPS at the end of the year, with a coupon rate of 1%. 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 2%, however, the $1,000 principal will be adjusted upward by 2% to $1,020. The coupon rate will still be the same at 1% but it will be multiplied by the new principal amount of $1,020 to get an interest payment of $10.20. On the other hand, if inflation was negative, as in deflation, with prices as measured by the CPI falling 5%, the principal would be adjusted downward to $950. The resulting interest payment would be $9.50 over the year.

At maturity, the investor would receive the principal equal to either the original principal of $1,000 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.

Risks of Treasury Inflation Protected Securities

TIPS usually carry interest rates lower than other government or corporate securities, so they are not necessarily optimal for income investors. Their advantage is mainly inflation protection, but if inflation is minimal or nonexistent, their utility decreases. Another risk associated with TIPS is a higher tax bill. The adjustments of principal are considered income for tax purposes, although investors do not receive the adjustments, but instead receive the coupons that result from them. Thus, investors may be subject to tax on "phantom income," with the gain in principal outweighing the coupons received.

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