Treasury Inflation-Protected Securities (TIPS) are a type of U.S. Treasury bond that is indexed to inflation to protect investors from the decline in the purchasing power of their money. Unlike traditional fixed-rate bonds, the principal of TIPS is adjusted based on changes in the Consumer Price Index (CPI), a measure of inflation.
How TIPS Work
When inflation occurs, as measured by the CPI, the principal of TIPS is increased proportionally. Conversely, if deflation occurs, the principal is decreased. At maturity, the investor receives the adjusted principal or the original principal, whichever is greater.
In addition to the adjusted principal, TIPS also pay a fixed interest rate. This interest rate is applied to the adjusted principal, so the actual dollar amount of interest payments will fluctuate with inflation.
Benefits of Investing in TIPS
- Inflation Protection: The primary benefit of TIPS is their ability to protect investors from inflation.
- Principal Protection: At maturity, investors are guaranteed to receive at least the original principal amount.
- Diversification: TIPS can be a valuable addition to a diversified investment portfolio.
- Government Backing: TIPS are backed by the full faith and credit of the U.S. government.
Risks of Investing in TIPS
- Deflation Risk: In a deflationary environment, the principal of TIPS will decrease.
- Interest Rate Risk: While TIPS protect against inflation, they are still subject to interest rate risk.
- Tax Implications: The increase in the principal of TIPS is taxable in the year it occurs, even though the investor does not receive the cash until maturity.
Who Should Invest in TIPS?
TIPS may be suitable for investors who are concerned about the impact of inflation on their investments and are looking for a relatively safe and liquid investment option. They are often recommended for retirees or those nearing retirement who want to preserve their purchasing power.
