Treasury Inflation Protected Securities

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.

Since the US treasury inflation-protected securities are issued by the US Treasury and provide 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.

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 bond is calculated as the interest rate (or coupon rate) 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.

TIPS protect investors from the inflation risk inherent 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.

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 deflation. 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.

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).

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.