"TIPS -- What are Treasury Inflation Protected Securities"

What are TIPS?

TIPS stand for Treasury Inflation Protection Securities. These Treasury inflation indexed securities were started in 1997 by then Secretary of the Treasury Robert Rubin. They're issued by the United States Bureau of Public Debt.

The basic purpose of Treasury TIPS was for the government to offer investors a way to save their money so that its purchasing power would be protected against inflation. Their principal is tied to the Consumer Price Index. (CPI-Urban, Non-Seasonally-Adjusted with a 3-month lag)

The CPI index at the time the TIPS bond is issued is called the base CPI or reference CPI.

When the CPI goes up, the TIPS principal is increased by the same percentage. In case of deflation, the TIPS principal would be decreased by the same percentage. The CPI ratio is the current CPI divided by the bond's base CPI. That calculates how the bond's principal should be adjusted.

This adjustment of TIPS principal is made every month

Because the TIPS principal is adjusted for changes in the CPI, the principal remains constant in terms of spending power. Your real return is the interest rate paid.

Plus, Treasury inflation protected securities TIPS pay a fixed rate of interest.

The rate of interest paid remains constant over the life of the TIPS treasury bonds. However, since it's paid on the principal, which can go up or down, the precise amount of each semi-annual interest payment can vary.

The rate of interest reflects the general market rate of interest at the time the TIPS bond is issued. Because of the protection from inflation offered by the bond, the coupon interest rate is lower than other Treasury bonds.

Inflation is the major risk of fixed income investments

That is because the yield of bonds, certificates of deposits and other such investments is fixed. That is, it remains one constant, set amount of money that does not go up or down over time.

Yet with time, thanks to inflation, the value of that set amount of money goes down in terms of what you can buy with it.

Inflation has been greatly reduced in the past two decades. If you're not old enough to remember the 1970s, it's hard for you to realize the impact on your budget of spending more per pound of ground beef every week.

TIPS work by establishing the fixed rate of interest they pay as the set, real return OVER inflation

That is, the principal of the U.S. Treasury TIPS bond may go up or down every year, but you will always receive the interest rate on top of a principal that remains fixed in terms of spending power.

Because inflation was running at a historically low figure when these inflation bonds were introduced, many people did not pay much attention. Soon, Internet stocks were skyrocketing to the moon.

Why care about a measly fixed real rate of return when you could buy shares of Yahoo!, Amazon or Dell Computer and see your investment multiplied hundreds of times?

So they did not get much media coverage or attention, and they've not been as popular as Rubin undoubtedly hoped they'd be.

Treasury TIPS pay interest every six months

You can buy TIPS with a life of 5, 10, 20, 20 and 30 years. The minimum purchase amount is $1000. You can buy more, in multiples of $1000.

There're about $300 billion of TIPS Treasury bonds outstanding.

Next: What are the risks of TIPS

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