How do Treasury Inflation-Protected Securities (TIPS) work?
Regular bonds pay interest on the principal amount of the bond which provides income for the bond owner. TIPS are different in two ways:
- The principal amount of the bond is changed according to the Consumer Price Index (CPI). It can go up or down.
- The interest payment is based on the current principal amount of the bond which can be different than the original principal amount.
A TIPS example
$10,000 TIPS bond at 3%.
In year 1 – two semi-annual payments totalling $300.
At the end of year 1, the CPI is 2% so the principal amount goes up by 2% to $10,200.
In year 2 the total interest payments will be 3% of the new principal or $306.
When the TIPS matures then you will receive either the current principal value or the original TIPS amount whichever is higher.
Benefits of TIPS
- Diversification – TIPS are not correlated with stocks or regular bonds.
- Inflation hedge – One of the few investments that has solid inflation protection.
- Safety – Backed by the US government.
- Tradeable – TIPS can be bought and sold before maturity.
Drawbacks to TIPS
- These bonds will lose value in periods of deflation.
- Should only be in a non-taxable account such as a Roth IRA. In periods of high inflation – the annual increase in principal value will be taxable income but the increase won’t be paid to you until the TIPS matures. If inflation is high enough then your annual taxes might approach or even exceed the interest payments in a taxable account.
- TIPS inflation changes are based on CPI changes which might not be accurate.
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