Treasury Inflation Protected Securities

Updated on January 5, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is a Treasury Inflation-Protected Security?

Treasury inflation-protected securities (TIPS) are those inflation-indexed bonds that are issued by the government of the United States of America. 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 inflation), thus hedging the inflation risk of the bond.

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Since the US treasury inflation-protected securities are issued by the US Treasury and provide a hedge against the inflation riskInflation RiskInflation Risk is a situation where the purchasing power drops drastically. It could also be explained as a situation where the prices of goods and services increase more than expected. Inflation Risk is also known as Purchasing Power Risk.read more, they are considered a very low-risk investment. They are issued in three maturities of five, ten, and thirty years.

Key Takeaways

  • Treasury Inflation-Protected Securities (TIPS) are bonds issued by the U.S. government that stand out for their inflation-linked features. Their principal value is tied to an inflation index, such as the U.S. Consumer Price Index. 
  • TIPS are considered extremely low-risk investments due to their issuance by the U.S. Treasury. They offer an essential hedge against inflation risk. 
  • These bonds come in three maturity options: five, ten, and thirty years, allowing investors to tailor their investment horizon according to their preferences.
  • As economic inflation surpasses the bond coupon rate, the periodic coupon value of TIPS adjusts downward due to rising prices. 

How Treasury Inflation-Protected Security Works?

Treasury inflation-protected security is a type of bond issued by the US Treasury that is anchored by an inflationary gauge which helps them protect their money’s value falling due to inflation. Moreover, the treasury inflation protected securities yield is also an obvious motivator for the investment.

The principle of TIPS security is linked to an inflation index. As inflation in the economy rises, the bond’s principal or face value goes up. The coupon of a bondCoupon Of A BondCoupon bonds pay fixed interest at a predetermined frequency from the bond’s issue date to the bond’s maturity or transfer date. The holder of a coupon bond receives a periodic payment of the stipulated fixed interest rate.read more is calculated as the interest rate (or coupon rateCoupon RateThe coupon rate is the ROI (rate of interest) paid on the bond's face value by the bond's issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100%read more) multiplied by the bond’s principal.

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 them from the inflation risk. Conversely, if deflation (prices of goods and services) goes down, then the principal of TIPS goes down, and investors will receive lower coupons.

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TIPS protect investors from the inflation risk inherentRisk InherentInherent Risk is the probability of a defect in the financial statement due to error, omission or misstatement identified during a financial audit. Such a risk arises because of certain factors which are beyond the internal control of the organization.read more in the economy. If the inflation in the economy is higher than the bond coupon rate, then the value of the periodic coupon is eroded in real terms because of the higher prices. In such cases, TIPS protect the investors as they adjust the principal of the bond to the inflation; 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 protect 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 looking at the future predicted trend.

Examples

Let us understand the concept of US treasury inflation protected securities and their intricate details with the help of a few examples.

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%. The investor is at a loss in real terms as inflation has completely eroded the value of the coupon payment. TIPS protects 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, suppose there is an inflation of 4% in the economy. In that case, the bond’s original USD 100 face value 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 the inflation rate persists at 4% at maturity, the investor will receive the inflation-adjusted principal of USD 104. Thus, with increased coupon and principal payment at maturity with an increase in inflation, TIPS protects 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 deflationDeflationDeflation is defined as an economic condition whereby the prices of goods and services go down constantly with the inflation rate turning negative. The situation generally emerges from the contraction of the money supply in the economy.read more. However, at the bond’s maturity, the investor will be nothing less than the original face value of the bond, which 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 amount invested or the adjusted higher principal.

Advantages

Apart from beating the inflation rate or hedging the risk of inflation eating away at the gains made through investments, there are other advantages of the treasury inflation protected securities as well. Let us understand them through the points below.

  • 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, the 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 bond’s original face value (principal).

Disadvantages

Despite the various advantages of the US treasury protected securities, there are a few factors that prove to be a hassle for investors. Let us understand the disadvantages of this concept through the explanation below.

  • 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 coupon payments are higher with increased inflation.
  • In the case of inflation in a flattish economy, 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.

Frequently Asked Questions (FAQs)

1. How to buy treasury inflation-protected securities? 

You can buy Treasury Inflation-Protected Securities (TIPS) directly from the U.S. Department of the Treasury through their website, TreasuryDirect. You’ll need to create an account, provide the necessary information, and follow the instructions to purchase TIPS through auctions or secondary market transactions. Alternatively, you can buy TIPS through brokers, banks, or financial institutions that offer them.

2. How are treasury inflation-protected securities taxed? 

While TIPS interest is subject to federal income tax, the interest payments are adjusted for inflation. This means you’ll pay taxes on both the actual interest received and any inflation-adjusted interest. State and local taxes also apply. TIPS are unique in that investors are taxed on the inflation-adjusted interest even before they receive it, which might lead to “phantom income.” 

3. Are treasury inflation-protected securities a good investment? 

TIPS can be a good investment for those seeking protection against inflation. They offer a fixed interest rate along with adjustments for inflation, ensuring the real value of your investment is preserved. While they provide inflation protection, their yields might be lower than other fixed-income investments. TIPS are particularly attractive during periods of expected inflation.

This has been a guide to what is a Treasury Inflation-Protected Security (TIPS). Here we explain how they work along with examples, and advantages. You can learn more about fixed income from the following articles –

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