Treasury Inflation Protected Securities

The United States Treasury currently offers a special kind of security, called a Treasury Inflation-Protected Security (TIPS), whose principal amount is adjusted for inflation. The Treasury Department regularly auctions TIPS with 5-year, 10-year and 20-year maturities. The Treasury introduced these instruments in 1997, based on the premise that the issuance of TIPS would reduce interest costs to the Treasury over the long term and would increase the different types of investors that buy their debt instruments. TIPS have been very popular among certain classes of investors looking to hedge their interest rate and inflation exposure.

They offer a number of potential benefits for investors. Like ordinary US Treasuries, they are backed by the full faith and credit of the government. Unlike ordinary US Treasuries, the principal is protected against inflation. Since the principal is linked to inflation, investors are guaranteed that the real purchasing power of the principal will keep pace with the rate of inflation.

How TIPS Work

TIPs are sold like other Treasury bonds, at auction. The interest that a TIPS pays is determined by this auction and fixed for the life of the security. What varies and adjusts according to inflation, is the principal.

The princpal of a TIPS is adjusted semi-annually based on the inflation rate as reported by Consumer Price Index for Urban Consumers (CPI-U). CPI-U was selected by Treasury because it is the best known and most widely accepted measure of inflation. TIPS pay semi-annual payments based on the principal and the adjusted amount. So, the inflation rate adjusts the principal that is used to calculate the interest payment.

Let's look at an example:

Supposed you invested $10,000 in January in a 10-year TIPS with a fixed 3% fixed payment.

• If inflation was 1% in the first six months then at the mid-year point the value of the security would be $10,100 ($10,000 * 1.01 = $10,100).
• At this mid-year point, the investor would also receive a payment of $151.50 ($10,100 * 3% = $303 divided by 2).
• If inflation then grew to 4% for the last six months of the year, the new value of the security would be $10,400 ($10,000 * 4% = $10,400).
• The second semiannual interest payment would be $156 ($10,400 * 3% = $312 divided by 2).

When the TIPS matures you receive the adjusted principal value or the original TIPS investment, whichever is higher.

The semiannual interest payments on TIPS are taxable to a holder of securities when received (consistent with the tax treatment of other Treasury securities). However, investors will also be taxed on inflation adjustments to the principal in the year in which the adjustments occur, even though the principal adjustments would not actually be received from Treasury until maturity (a situation that is sometimes described as taxing "phantom income").

Auctions

TIPS are auctioned according to the following schedule:

5-year TIPS - April, *August, *December

10-year TIPS - January, *March, *May, July, *September, *November

30-year TIPS - February, *June, *October

* This is a reopening. In a reopening, Treasury sells an additional amount of a previously issued security. The reopened security has the same maturity date and interest rate as the original security. However, as compared to the original security, the reopened security has a different issue date and usually a different purchase price.

What to Look for with Treasury Inflation Protected Securities:

If you are concerned about inflationary pressures, these securities offer better protection than ordinary Treasuries.

Avoiding Pitfalls with Treasury Inflation Protected Securities:

There are several potential pitfalls to TIPS that an investor should consider.

1. The CPI-U is not an accurate guage of inflation. Many investors and economists believe that the CPI-U tends to undercount inflation. As a result, TIPS may not fully protect an investor from rising yields. Still, although potentially flawed, an investor receives more protection than in vanilla Treasuries.
2. Deflation may reduce the value of TIPS. In the event of sustained deflation, the amount of the semiannual interest payments and the inflation-adjusted principal amount of the security will decrease. However, if at maturity the inflation-adjusted principal amount is less than a security's original value, an additional amount will be paid at maturity so that the additional amount plus the inflation-adjusted principal amount equals the original investment.

Purchasing TIPS

TIPS can be purchased by individual investors directly from the U.S. Treasury at auction or from an investment professional, commercial bank, or online broker. They can be purchased individually or via a mutual fund. For individual purchases, the minimum is $100.