Treasury Inflation-Protected Securities (TIPS) are bonds issued by the U.S. Treasury whose principal is adjusted by changes in the Consumer Price Index (CPI). With inflation (a rise in the CPI), the principal increases. With a deflation (a drop in the CPI), the principal decreases.
TIPS are considered a low-risk investment since they are backed by the U.S. government and since their par value rises with inflation, while their interest rate remains fixed. Interest on TIPS is paid semiannually and is subject to federal taxes, but is exempt from state and local income taxes.
The relationship between TIPS and the CPI affects both the sum you are paid when your TIPS matures and the amount of interest that a TIPS pays you every six months. While TIPS pay interest at a fixed rate, because the rate is applied to the adjusted principal, interest payments can vary in amount from one period to the next. If inflation occurs, the interest payment increases. In the event of deflation, the interest payment decreases.
The price of a TIPS can be less than, equal to, or greater than the face value. At the maturity, you receive the adjusted principal or the original principal, whichever is greater. This provision protects you against deflation.
Individual TIPS can be purchased directly, or via mutual funds and ETFs that invest solely or partially in TIPS.1 There are two ways to bid for individual TIPS.
- Noncompetitive bid — You agree to accept the yield determined at auction. With this type of bid, you are guaranteed to receive the TIPS you want, and in the full amount you want (the minimum amount is $100 and you can purchase in $100 increments).
- Competitive bid — You specify the yield you are willing to accept. Your bid may be:
- Accepted in full if your bid is less than the yield determined at auction,
- Accepted in less than the full amount if your bid is equal to the high yield, or
- Rejected if the yield you specify is higher than the yield set at auction.
To place a noncompetitive bid, you may use TreasuryDirect, Legacy Treasury Direct, or a bank, broker, or dealer. Competitive bids must be made via a bank, broker, or dealer.
And remember, as with all investing, risk tolerance and proper allocation are key. While TIPS are great for some investors, they’re not right for everyone, and certainly not right for an entire portfolio or even a majority of a portfolio.
1Investing in mutual funds and ETFs involves risks, including loss of principal.
© 2012 S&P Capital IQ Financial Communications. All rights reserved.