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The United States
Treasury currently offers a special kind of security,
called a Treasury Inflation-Protected Security (TIPS),
whose principal amount is adjusted for inflation. The
Treasury Department regularly auctions TIPS with 5-year,
10-year and 20-year maturity. The Treasury introduced
these instruments in 1997, based on the premise that
the issuance of TIPS would reduce interest costs to
the Treasury over the long term and would increase the
different types of investors that buy their debt instruments.
Although TIPS do bear a significant risk of loss and
are therefore not a cash equivalent, they have been very
popular among certain classes of investors looking to
hedge their interest rate and inflation exposure.
TIPS can be purchased by individual investors directly
from the U.S.
Treasury at auction or through primary brokers.
They offer a number of potential benefits for investors.
Like ordinary US Treasuries, they are backed by the
full faith and credit of the government. Unlike ordinary
US Treasuries, the principal is protected against inflation.
Since the principal is linked to inflation, investors
are guaranteed that the real purchasing power of the
principal will keep pace with the rate of inflation.
For example, if you were to buy a $1,000 TIPS bond and
inflation were to rise at a 2% annual rate, the bonds
would have an adjusted face value of $1,020 after one
year. As inflation fluctuates, the bond's value and
interest payments would too. The inflation adjustment
becomes payable by the US Treasury at maturity when
the securities will be redeemed at their inflation-adjusted
principal amount, but at a price no less than the par
issue price.
Interest is also protected from inflation as investors
receive semiannual interest payments, based on a fixed
semiannual interest rate applied to the inflation-adjusted
principal, and are therefore guaranteed a real rate
of return above inflation.
The index for measuring the inflation rate is the nonseasonally
adjusted Consumer Price Index for
Urban Consumers (CPI-U). CPI-U was selected by Treasury
because it is the best known and most widely accepted
measure of inflation.
The semiannual interest payments on TIPS are taxable
to a holder of securities when received (consistent
with the tax treatment of other Treasury securities).
However, investors will also be taxed on inflation adjustments
to the principal in the year in which the adjustments
occur, even though the principal adjustments would not
actually be received from Treasury until maturity (a
situation that is sometimes described as taxing "phantom
income").
Issue / Term | Maturity Date | Coupon | Price | Yield |
5 Year |
4/15/2013 |
1.25% |
103-14 |
0.43% |
10 Year |
7/15/2019 |
1.875% |
103-28 |
1.43% |
20 Year |
1/15/2029 |
2.50% |
107-08 |
2.04% |
30 Year |
4/15/2032 |
3.375% |
123-14 |
2.06% |
If you are
concerned about inflationary pressures, these securities
would tend to offer better protection than ordinary
Treasuries.
Like Treasuries or any longer term fixed income investment, these securities bear certain risks. An investment in securities with principal or interest determined by reference to an inflation index involves factors not associated with an investment in a fixed-principal security. Such factors may include the possibility that the inflation index is rear-facing and may not reflect inflation immediately. The resulting interest may be greater or less than that payable on other securities of similar maturities and that, in the event of sustained deflation, the amount of the semiannual interest payments and the inflation-adjusted principal amount of the security will decrease. However, if at maturity the inflation-adjusted principal amount is less than a security's par amount, an additional amount will be paid at maturity so that the additional amount plus the inflation-adjusted principal amount equals the original par amount.
There are two ways to bid and purchase TIPS - a competitive bidding process or a noncompetitive bidding process.
Interest on TIPS is local and state tax exempt but is subject to Federal Tax. The tax is levied on the interest payments in the year they are received and on yearly on the growth in princpal. Thus, if you own a 20-year TIPS, you could be paying taxes annually even if the bond has not matured. That's why many investment advisors recommend keeping tips in a IRA or tax sheltered investment vehicle.
TIPS are bonds not cash and as a result their prices can vary significantly based on the market. Like other bonds, TIPS can be held to maturity or sold.
Instead of purchasing individual TIPS you can also invest in TIPS mutual funds. Vanguard's Inflation-Protected Securities (VIPSX) fund, and the iShares Barclays Treasury Inflation Protected Securities Bond exchange-traded fund (TIP), are both about 70% invested in bonds that mature within ten years or less. Bond giant Pimco recently launched TIPS PIMCO 15+ Year U.S. TIPS Index Fund (LTPZ), an exchange-traded fund that specializes in long-term.