Treasury Inflation-Protected Securities (TIPS) are a type of notes and bonds issued by the U.S. Treasury. TIPS are unique because their principal and interest payments are indexed to the rate of inflation as measured by the Consumer Price Index. Therefore TIPS provide explicit inflation protection not offered by the other nominal bonds. [1]

Contents

How it works

After a TIPS bond is issued, its principal is adjusted daily using the Non-Seasonally Adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U ). If there is inflation, the adjusted principal goes up. If there is deflation, the adjusted principal goes down. When the bond matures, the U.S. Treasury pays the original or the adjusted principal, whichever is greater. The principal adjustment factor is called the Index Ratio. The adjusted principal is the original principal multiplied by the Index Ratio. After the CPI-U number is announced for the previous month, the Treasury Department publishes the daily index ratios for the following month. For example, the CPI-U number for May is announced in June. The inflation during the month of May is prorated in the Index Ratios throughout the month of July and reflected fully in the Index Ratio by the end of July. Therefore the inflation adjustment has a lag of two months. [2]

Like regular bonds, a TIPS bond also pays interest twice a year. The semi-annual interest is calculated by multiplying the adjusted principal by one-half of the interest rate on the bond. For example, if a TIPS bond has a stated interest rate of 2% and the index ratio is 1.035 on the date of the interest payment date, a $1,000 bond will pay interest of

If the index ratio goes to 1.050 on the next interest payment date six months later, the same bond will pay interest of

If the index ratio goes to 0.985 on the next interest payment date another six months later, the same bond will pay interest of

When there is inflation, both the TIPS principal and the interest payments go up with inflation. When there is deflation, both the TIPS principal and the interest payments go down with deflation. On the date of maturity, if the inflation adjusted principal value is below the original face value, the original face value will be paid.

Risks

Role in a portfolio

TIPS belong to the Bonds category. Their role in a portfolio is similar to that of other bonds. Because unexpected inflation is the biggest enemy of fixed income securities and because TIPS offer unique inflation protection, investors should consider including TIPS in their investment portfolio.

Another important aspect of TIPS is that it is expected to work as a good diversifier of the equity risk because it (and the inflation) tends to have slightly negative correlation with equities. [3]

How to buy

The Treasury Department sells TIPS a few times a year through auctions. After the auction, TIPS trade on the secondary market. You can buy TIPS at the time of the auction or you can buy on the secondary market at any time. You can also buy TIPS through a mutual fund or ETF.

At auction

Note. The Treasury auction process is not unique to TIPS. The following few paragraphs should be moved to a new article about buying Treasury notes at auction.

At this time, TIPS are issued in January, April, July and October. The auction dates are published in the Tentative Treasury Auction Schedule. A few days before the auction date, the Treasury Department also publishes a formal announcement. The announcement includes details of the security being offered. If it’s a new issue, both the price and the coupon interest rate will be determined by the auction. The coupon rate is set to nearest 0.125% below the high yield from the auction. If it’s a re-opening, the coupon interest rate is already known. The auction will set the yield which in turn determines the price. This online spreadsheet can help you estimate the dollars needed for buying one bond at auction.

After the announcement date but before the auction cutoff time, retail investors can place auction orders through TreasuryDirect or through a brokerage account. TreasuryDirect charges no fee but it only handles taxable accounts. If you want to buy in an IRA, you must use a brokerage account, which can also handle taxable accounts. As of September 2008, Fidelity and Schwab charge no fee for TIPS auction orders placed online. Vanguard Brokerage Services charges $10 for online orders unless you are a Voyager client or above (having more than $100,000 invested with Vanguard).

After the auction, the Treasury Department makes another announcement for the auction result. The settlement date is at least one day after the auction date. You must have enough cash available on the settlement date to pay for the bonds. [4]

On secondary market

You can also buy TIPS at any time on the secondary market through a brokerage account. The prices from the brokers include a markup over what institutions pay for larger trades. Some brokers also charge a separate commission on top of the markup. TreasuryDirect does not handle secondary market purchases although you can sell your existing holdings on the secondary market through its SellDirect service (fees and restrictions apply).

The following links show some current TIPS pricing and real yields available in the secondary market.

Through a mutual Fund or ETF

Buying TIPS through a mutual fund or ETF gives an investor a diversified portfolio of TIPS of different maturities. Buying through a mutual fund or ETF also makes it easier for tax reporting and reinvesting interest payments.The fact that a mutual fund or ETF distributes both the interest income and inflation adjustment of an inflation-indexed bond as income distributions brings the following cautions to mind:

1. An investor desiring inflation protection of principal must reinvest the inflation adjusted principle distribution back into the fund.
2. The inflation/deflation principal adjustment results in considerable variance in fund income dividend distribution. [5]

For more information on buying individual bonds or a bond fund, see Individual bonds vs a bond fund.

Popular TIPS mutual fund and ETF choices include: