Treasury Inflation-Protected Securities (TIPS) offer investors a way to safeguard their investments against the erosion of purchasing power caused by inflation. Unlike traditional fixed-income securities, the principal of TIPS is adjusted based on changes in the Consumer Price Index (CPI), a widely recognized measure of inflation.
How TIPS Work
The principal of a TIPS increases with inflation and decreases with deflation, as measured by the CPI. When a TIPS matures, the investor receives the adjusted principal or the original principal, whichever is greater. In addition to the adjusted principal, TIPS also pay interest twice a year at a fixed rate. However, the interest payment amount varies because it is calculated based on the adjusted principal.
Benefits of Investing in TIPS
- Inflation Protection: The primary benefit of TIPS is their ability to protect investors from inflation. As the principal adjusts with inflation, the real value of the investment is preserved.
- Principal Guarantee: At maturity, investors are guaranteed to receive at least the original principal amount, even if deflation occurs.
- Diversification: TIPS can be a valuable addition to a diversified investment portfolio, as they offer a hedge against inflation that is not correlated with other asset classes.
Considerations
While TIPS offer inflation protection, it’s important to consider a few factors:
- Tax Implications: The increase in principal due to inflation is considered taxable income in the year it occurs, even though the investor does not receive the cash until maturity.
- Real Interest Rates: TIPS typically offer lower interest rates than traditional Treasury securities because of the inflation protection they provide.
TIPS can be purchased directly from the U.S. Treasury through TreasuryDirect or through brokers and financial advisors. They are also available in the secondary market and through mutual funds and exchange-traded funds (ETFs).
