Treasury Inflation Protected Securities (TIPS) – What They are and How They WorkDecember 14th, 2011 by David Waring
Treasury Inflation Protected Securities (TIPS for short) are bonds issued by the US Treasury whose principal and coupon interest payments fluctuate along with inflation. More exactly, the principal value and coupon interest payment on a TIPS fluctuates along with changes in the Consumer Price Index, which is how inflation is measured.
Here is a video overview of Treasury Inflation Protected Securities, the text version of which you can find below the video.
TIPS are the only type of investment which offer both direct protection against inflation and are backed by the full faith and credit of the US Government.
When you buy new Treasury Inflation Protected Securities, they will have a “principal” of $1000 per bond. This means that you pay $1000 for each bond. With most types of bonds you would also get $1000 back at maturity, which is why the words “par” or “face” value are used with most bonds instead of “principal”.
With TIPS however, the value at maturity changes based on the inflation that occurs during the life of the bond.
This is why we use the word “principal” instead of “face” or “par” value. (The principal value is in fact adjusted everyday. This is important because, as we outline below, the coupon payment that you receive is the principal times the coupon rate).
You can buy Treasury Inflation Protected Securities from banks, brokers and TreasuryDirect (the website of the U.S. Treasury). TIPS are available with maturities of 5, 10 and 30 years. You can also resell them on the secondary market before they reach maturity. The initial price and the interest rate for a Treasury Inflation Protected Security is determined at the time when the U.S. Treasury auctions TIPS to potential buyers.
With other types of bonds, the principal value of the bond is fixed and does not fluctuate. This means that both the coupon rate and coupon payment are fixed over the life of the bond.
Because the principal value of a Treasury Inflation Protected Security fluctuates along with inflation, only the coupon interest rate is fixed for the life of the bond.
Therefore, the amount of interest you receive from one payment to another may go up or down. In simple terms, if inflation was to go up 5% between coupon payments, you could expect to see an increase in your coupon payment by 5%.
If you buy Treasury Inflation Protected Securities when they are issued, and then hold it to maturity it is a pretty straightforward investment. If you buy or sell a TIPS after it is issued or before it reaches maturity, it is a more complicated investment than a normal treasury bond.
The are several reasons Treasury Inflation Protected Securities can be more complicated than normal treasury bonds.
- With a normal treasury bond, the value of the bond moves up and down as a result of changes in interest rates only. As we have just explained above, TIPS also rise and fall in value with inflation, which adds another level of complexity when evaluating these bonds in the secondary market.
- Because the coupon payment is lower for a Treasury Inflation Protected Security than a normal bond issued by the Treasury, they are more volatile than comparable bonds without the inflation protection component.
For these reasons we recommend only investing in TIPS if you plan to hold them until maturity.