Treasury Inflation Protected Securities (TIPS)
First authorized in 1997, Treasury-Inflation Protected Securities, or TIPS, are securities issued by the U.S. Treasury whose principal is linked to the Consumer Price Index. TIPS offer investors the opportunity to buy bonds, while at the same time protect themselves against inflation.
What are TIPS?
The principal of Treasury-Inflation Protected Securities is linked to the Consumer Price Index (a common measure of inflation). When inflationary times exist, the principal of the security will increase. When a period of deflation exists, the principal will decrease. When the security matures, the Treasury will pay the owner the original principal amount, or the inflation-adjusted principal, whichever value is higher.
The coupon rate on TIPS is fixed, and interest is paid every six months. The size of the interest payment is determined by multiplying the adjusted principal times one-half the coupon rate. Since the coupon rate is held constant, and the principal moves up or down with inflation, the actual interest payment will vary over the life of the security. These are one of the few investments that offer the holder a true hedge against inflation.
This last point is the primary reason investors hold TIPS in their long-term portfolios; they offer protection against inflation. These bonds are also a steady source of income when markets are turbulent. They are issued by the U.S. government, which means the risk of default is close to zero, and there is also a robust trading market for these securities.
The current offering of TIPS includes 5-year, 10-year, and 20-year maturities. As mentioned earlier, the interest rate on the bond is fixed, and interest payments are made semiannually. The interest paid to the holder is always based on the adjusted principal.
The principal of TIPS is adjusted on a monthly basis, and that adjustment is based on the Consumer Price Index-Urban, Non-Seasonally Adjusted index, with a 3-month lag. Just like other marketable securities, TIPS can be sold prior to maturity. Even though the principal is adjusted for inflation each month, the inflation-adjusted principal will not be paid until the maturity date.
When TIPS do mature, the holder is paid the inflation-adjusted principal, or the original principal, whichever is the larger amount.
In addition to their value as a hedge against inflation, TIPS can also be a used by policymakers. By taking the current interest rate paid on 10 Year Treasury Notes, and comparing it to the interest rate on a Treasury Inflation-Protected Security, it's possible to calculate the interest rate differential.
This differential represents the premium investors are willing to pay in order to eliminate the risk of inflation. By examining this interest rate differential over time, policymakers can understand the market's change in expectations for inflation.
Treasury Inflation-Protected Securities are offered to the market through auctions. These work the same way as the other single-price auctions used with other Treasury-issued securities. Bids for Treasury securities may be submitted as competitive or noncompetitive bids:
- Competitive Bids: the bidder identifies an acceptable yield on the bond. The bid is accepted in-full if the rate identified is less than the yield determined by the auction. The bid may be accepted in less than the full amount, if the bid is equal to the high yield. Finally, the bid is rejected if the rate identified is higher than the final yield established at the auction.
- Noncompetitive Bids: the bidder agrees to accept the final yield determined at auction. Noncompetitive bidders are guaranteed to receive the full amount of the security bid.
The minimum purchase at auction for TIPS is $1,000. The maximum purchase for a noncompetitive bid is $5 million. All investment amounts must be in multiples of $1,000. Competitive bids need to comprise 35% of the total offering's value.
Auctions of 5-year TIPS occur in April, and re-openings are scheduled in October. Auctions of 10-year TIPS occur in January and July, and re-openings are scheduled in April and October. Auctions of 20-year TIPS occur in January, and re-openings are scheduled in July.
A re-opened security has the same maturity date and interest payment schedule as the original security, but the issue date and price paid will be different.
Noncompetitive bids can be made by investors through TreasuryDirect. In order to place a competitive bid, the bidder must use a broker, financial institution, or have an established TAAPSLink account.
As is the case with many fixed-income securities, federal income taxes are due on the interest payments in the year they are received. Interest payments on TIPS are exempt from state and local income taxes. Any inflation adjustment, or growth, that occurs to the value of the bond is taxable in the year the adjustment is made to the bond.
One of the criticisms, or the primary disadvantage, of this type of security has to do with the payment of income taxes on the growth in the bond's principal. For example, when inflation is high, the holder of the security is receiving a larger "inflation-protected" interest payment. But those higher payments are a result of a growth in principal; the coupon rate is fixed. The undesirable consequence of this mechanism is the additional payment of taxes on the growth in the security's value.
By holding these securities in a tax-deferred retirement account such as a 401(k) plan, Traditional IRA, Roth IRA, or 403(b) plan (to name just a few of these options), it is possible to postpone payment of income taxes on both the interest payments as well as any growth in principal.
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