Treasury Inflation-Protected Security Definition
Treasury inflation-protected securities (TIPS) are those inflation-indexed bonds that are issued by the government of the United States of America, and since its principal is indexed to an inflation index (US Consumer Price Index), it provides a hedge to the inflation risk. With increasing inflation, the principal values of TIPS also go up (as the principal of the bond is linked to the inflation), thus hedging the inflation risk of the bond.
Since the treasury inflation-protected securities are issued by the US Treasury, and it also provides a hedge against the inflation risk, they are considered a very low-risk investment. They are issued in three maturities of five, ten, and thirty years.
How Treasury Inflation-Protected Security Works?
The principal of a TIPS security is linked to an inflation index. As inflation in the economy rises, the principal or the face value of the bonds goes up. The coupon of a bond is calculated as the interest rate (or coupon rate) multiplied by the principal of the bond.
Now in an inflationary environment, the coupon of a bond which is paid periodically (quarterly, semi-annually, or annually), also increases in the corresponding period (due to increased principal), which results in higher coupon payment to the investor and thus protecting him/ her from the inflation risk. Conversely, if there is deflation (prices of goods and services) going down, then the principal of TIPS goes down, and investors will receive lower coupons.
Treasury Inflation-Protected Security Examples
Given below are the examples of Treasury Inflation-Protected Securities (TIPS).
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Example #1
Fixed-rate bonds carry the risk that inflation erodes the values of the coupon payment as the coupon interest, and thus the coupon amount of the bond is fixed for the bond’s life.
For example, if a bond pays a coupon of 3% annually over the life of the bond and the current inflation rate in the economy is 4%, then the investor is in a loss in real terms as inflation has completely eroded the value of the coupon payment. TIPS protect the investors in such scenarios.
Example #2
Suppose an investor owns USD 100 in Treasury Inflation-Protected Securities with a coupon rate of 2% annually. If there is no inflation in the economy, the investor will receive a coupon payment of USD 2 annually. However, if there is an inflation of 4% in the economy, the original USD 100 face value of the bond will be adjusted to USD 104, and the coupon payments of the security will now be calculated on USD 104 principal.
So the new coupon payments of the security will be USD 104 * 2% = USD 2.08. If, at maturity, the inflation rate persists at 4%, the investor will receive the inflation-adjusted principal of USD 104. Thus, with increased payment of coupon and principal at maturity with an increase in inflation, TIPS protect the investor from inflation risk.
Example #3
Suppose there is a deflation in the economy, i.e., prices of goods and services are going down. The deflation in the economy is 2%. The principal of the Treasury Inflation-Protected Securities will be adjusted downwards to USD 98, and the coupon payments will be calculated on the USD 98 face value.
In this case, coupon payments will decrease in value with deflation. However, at the maturity of the bond, the investor will be nothing less than the original face value of the bond that is USD 100. So, one big advantage of TIPS is that in case of deflation, the principal value of the security is not adjusted at maturity, and the investor receives a higher of the amount invested or the adjusted higher principal.
Advantages of TIPS
- It provides a hedge against the inflation risk. The principal of a treasury inflation-protected security is adjusted with the inflation trend in the economy; thus, principal and coupons are inflation-adjusted.
- Coupon payments of TIPS increase in an inflationary environment as it is calculated on the inflation-adjusted principal.
- When the TIPS mature, investors are never paid less than the original face-value (principal) of the bond.
Disadvantages of TIPS
- Since they provide a hedge against the inflation risk, the coupon rate of TIPS security is generally lower than that of a comparable fixed-income instrument without an inflation adjustment
- TIPS, generally are subject to higher taxes as the coupon payments are higher with increased inflation.
- In the case of inflation in an economy that is flattish, investing in TIPS is of little use as the face value of the bond will remain more or less constant due to the non-inflationary trend.
Conclusion
TIPS protect the investors from the inflation risk inherent in the economy. If the inflation in the economy is higher than the coupon rate of the bond, then the value of the periodic coupon is totally eroded in real terms because of the higher prices. In such cases, TIPS provide protection to the investors as they adjust the principal of the bond to the inflation and thus, both principal and coupon are linked to inflation and protected. Higher the inflation, the higher the principal, and coupon payments.
However, TIPS generally carry lower coupon rates as they provide protection to the investors from inflation risk. Also, investing in TIPS in a non-inflationary environment will lead to lower returns. Thus, investment in TIPS should be made after analyzing the current inflation trend in the economy and also looking at the future predicted trend.
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