While many of you have been offered tips on investing, this may be the first time you’ve gotten tips on what’s commonly known as TIPS—Treasury inflation-protected securities. Introduced by the U.S. Treasury in 1997, TIPS are fixed-income securities, sold in multiples of $1,000, whose principal value is indexed to the Consumer Price Index (CPI). This helps you—the bondholder— offset the risk that inflation will decrease the value of your principal.
Why is this worthwhile? While Treasuries carry almost no risk of default, they are subject to the ups and downs of interest rates. Therefore, if you want to sell a Treasury bond before it matures, the value of your principal may be less than what you paid. The other concern is that although you are sure you’ll get the full value of your principal back when the bond matures in, say, ten years, your purchasing power will likely be reduced due to inflation.
If you buy a TIPS, however, the semiannual interest you receive is calculated as one-half of the interest rate (determined at auction) multiplied by the inflation-adjusted principal. This means that you will always receive a real rate of return above the inflation rate (but in the unlikely event of deflation, your interest payments will decrease). At maturity, the bond is redeemed at its inflation-adjusted principal amount or its par value, whichever is greater. Therefore, you will likely receive more at redemption than you paid at purchase. You can’t receive less.
Which is better for you to hold: regular Treasury bonds or TIPS? The answer isn’t absolute, but, as a rule, if you think inflation is rising, you’d do better with TIPS. But realize that you have to pay income tax each year on the inflation adjustments you receive from TIPS—even though you won’t get the actual cash until the bond matures. This makes TIPS most appropriate for tax-deferred accounts. In addition, you should probably only buy a TIPS if you plan to hold it until maturity. Unlike many traditional bonds, it can be difficult to sell a TIPS.
Note: Other variations of principal-protected notes are available in the marketplace. Inflation-indexed savings bonds (I-Bonds), a variation of the tried-and-true U.S. government savings bonds, are also indexed to provide a hedge against inflation and are sold at face value in increments as small as $50. These bonds offer a guaranteed annual rate that remains in effect for the life of the bond as well as an additional rate that is tied to the CPI and adjusted every six months.