Treasury Inflation Protected Securities (TIPS) are a unique and useful form of Treasury issued securities. What makes them special is their expressed and close linkage to inflation levels in their coupon payments. They are set up this way to safeguard investors from the interest destroying impacts of inflation.
TIPS prove to be lower risk investments because they enjoy the expressed and unlimited backing of the U.S. government. Besides this, their par value increases at the same pace as the official rate of inflation as depicted by the CPI Consumer Price Index. The interest rate itself stays fixed with these investments.
The interest earned by these Treasury Inflation Protected Securities pays out twice a year on the same fixed dates. TIPS may be bought directly off of the U.S. government by utilizing the Treasury Direct system. This allows for simple $100 increment purchases of the TIPS in a minimum of only $100 order size. They can be obtained from the site with 30 year, 10 year, and 5 year maturity date options.
Unfortunately for the Treasury Inflation Protected Securities holders, the inflation adjustments of the TIPS bonds fall under the IRS definition of taxable income. This is the case despite the fact that investors do not realize any of those inflation adjusted gains until the point where the bonds mature or they sell out their holdings. Because of this, some investors opt to obtain their TIPS exposure by utilizing a TIPS mutual fund or ETF. Otherwise, they could simply buy and hold them within tax deferred retirement accounts like IRAs. This would save them the tax headaches of having to pay the IRS now on money they will not obtain for possibly years or even decades.
On the other hand, buying TIPS directly means that investors sidestep the costs and fees applied by mutual funds and even ETFs. TIPS bought directly also feature complete exemption from the double or even triple taxation of local income and state income taxes which some investors must pay, depending on where they reside. Residents of Puerto Rico do not have to pay any federal income taxes on these inflation adjusted gains or interest payments because of the Commonwealth’s completely unique status which it enjoys within the U.S.
If investors purchased $1,000 worth of TIPS and held them through year end and received one percent coupon rates while there was no CPI measured inflation within the United States, the investors could count on obtaining $10 payments for the entire year in interest payments. Assuming inflation increases by two percent, the principal of the bond would increase by two percent or in this specific instance by $20, to reach a total value of $1,020. The coupon rate would remain locked at one percent, yet it would apply to the entire new principal amount of $1,020 to help the holder receive interest payments of $10.20.
In the extremely unlikely event that deflation reared itself, the bonds would similarly decline in total face value. Should the CPI decline by three percent, the principle would drop by three percent, or $30, resulting in a new par face value of $970 on the formerly $1,000 Treasury bond. This would reduce that next year’s interest coupon payments total to $9.70.
When the bonds mature, investors would then get the principal equity which equated either to the $1,000 original par face value, or an applicably higher adjusted principal based on the CPI adjustments higher. Interest payments throughout the life of the bond will be calculated from the principal amount as it rises or falls. This does not apply to the downside if the investors hold their TIPS until they reach maturity. Investors who do not wish to hold their TIPS until this interval can choose to receive a lower amount of principal than the par face value by selling their investment via the secondary bonds market if they so desire.