What are TIPS and how do they work?
Q: What are TIPS and how do they work?
A: Similar to nominal (non-inflation-adjusted) U.S. Treasury fixed income investments, TIPS are issued with fixed coupon rates and fixed maturity dates (such as five, 10 or 20 years). The key difference between TIPS and nominal bonds is that the coupon rate for TIPS is a guaranteed “real” (inflation-adjusted) return. The principal is adjusted for inflation before the interest payment is calculated. With TIPS, the coupon payments and face value will maintain purchasing power until maturity. TIPS rates are primarily higher because they compensate for expected inflation and, secondarily, for the inflation risk premium.
The principal value of TIPS is adjusted by the Treasury Department according to changes in the Consumer Price Index for All Urban Consumers (CPI-U). The semiannual interest payments vary because the fixed coupon rate is applied to the inflation-adjusted principal, as illustrated here:
|
Year |
Inflation Rate |
Amount Principal Adjustment |
Adjusted Principal Value |
Total Coupon Payment |
|
1 |
0% |
$0.00 |
$100,000 |
$3,000 |
|
2 |
2% |
$2,000 |
$102,000 |
$3,060 |
|
3 |
1% |
$1,020 |
$103,020 |
$3,090.60 |
|
4 |
3% |
$3,090.60 |
$106,110.60 |
$3,183.32 |
|
5 |
1% |
$1,061.11 |
$107,171.71 |
$3,215.15 |
Note: Example assumes an individual TIPS with a $100,000 principal value and a 3 percent coupon rate.
Benefits and drawbacks of TIPS. TIPS diversify portfolios because of their low correlation to stocks. When inflation is higher than expected, TIPS typically outperform nominal Treasuries. Because TIPS are Treasury securities, they are considered risk free. They have lower volatility than nominal Treasuries and other investments considered being hedges against inflation (such as commodities, equities, real estate).
TIPS have lower expected returns than nominal Treasuries, which take on additional risk. TIPS are expected to underperform nominal Treasuries during periods of deflation.
The tax implications of TIPS. TIPS are exempt from most local and state taxes. Interest paid on TIPS held outside of tax-deferred accounts is considered ordinary income for federal income tax purposes. Also, increases to the inflation-adjusted principal are considered taxable income in the year they occur, even though TIPS investors do not actually receive these gains until the fixed income investments mature. Because of this tax inefficiency, TIPS should generally be held in tax-deferred accounts unless the investor is in a low tax bracket.
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