TIPS, are they for you?
Treasury inflation-protected securities, or TIPS, are one answer to the inflation risk problem that all bond investors face. All investors, particularly long-term investors, can lose a substantial portion of the purchasing power of their invested funds due to a gradual increase in price. TIPS can help prevent this from happening.
TIPS are marketable, book-entry debt securities. They are issued by the U.S. Treasury and are sold by the government at a quarterly auction, in minimum amounts of $1,000. TIPS are issued with maturities of 5, 10, and 20 years and at maturity, the inflation adjusted principal amount is paid.
TIPS carry a fixed annual interest rate and pay interest twice a year. The inflation protection aspect of TIPS is provided by adjusting the principal amount of the security according to changes in the inflation rate. The semiannual interest payment is then calculated based on the adjusted principal amount.
For example, if an investor purchases a $5,000 TIPS bond, paying 3.5% annual interest, in January. By July, when the first interest payment is due, inflation has increased 1.5%. The adjusted principal amount of the bond is now $5,075. The interest payable at that time is $88.81, calculated as $5,075 x 3.5% divided by 2. If by January of the following year, when the second interest payment is due, inflation had run at 3.5% for the entire year, the principal amount of the bond would be $5,175. The second interest payment would be $90.53, calculated as $5,175 x 3.5% divided by 2.
However, in a deflationary market, the principal amount of the TIPS is adjusted downward, resulting in an interest payment that may be less than the stated payment. If after the bond reaches maturity, the adjusted principal amount is less than the principal amount at issue, an additional amount will be paid to return the bond investor to at least the original principal amount.
However, as with all investment, there is some risk involved. The major risk with TIPS is if a bond is sold before maturity, the bond investor may receive less than originally paid. If an investor buys a TIPS and holds it to maturity, the government is obligated to repay at least the original principal amount. Again, the risk is, if a bond is sold before it matures the investor may receive less than originally paid, due to fluctuations in the market ultimately affecting the market value of a TIPS.
There are some important tax issues with regards to TIPS. Interest income from TIPS is treated in the same way as interest from other direct obligations to the U.S. federal government. Interest income from TIPS is taxable by the federal government, but is usually exempt from state and local tax.
One unique aspect of TIPS is that any adjustment of the principal amount is current taxable interest income. Looking at the example above, the investor would have $163.81 of taxable interest income for the first year. Of that, $88.81 of the interest was received as cash, and $75.00 in the form of an inflation adjustment to the principal amount.
Although TIPS are issued and guaranteed against default by the federal government, they are also marketable securities and can be bought and sold in the open market. TIPS prices in the open market can move up and down. Price move most often in response to changes in the general level of interest rates. Usually, if rates rise, the price of an existing bond will fall and if interest rates decline, the market value of existing a bond will increase.
There are investment uses for Treasury inflation-protected securities. TIPS can serve as a source of periodic income, for investors looking to meet current expenses. The inflation adjustment feature of these bonds is usually the main attraction for many fixed income investors. TIPS can also be a useful investment in a tax-deferred IRA or qualified retirement plan. However, the current taxable income nature of the inflation adjusted principal amount may be a downside for some investors.
There are two ways to invest in TIPS; direct and indirect ownership. With direct ownership, investors own TIPS directly. TIPS are bought in their own names using either an account with a securities brokerage firm or an online account with the Treasury Department. For more information on an online account with the U.S. Treasury Department:
Please visit http://www.treasurydirect.gov. Indirect ownership is the second way to invest in TIPS. With indirect ownership, open-end investment companies, known as mutual funds, pool the resources of many individuals, and offer an investor access to a diversified, professionally managed portfolio.