The Basics of TIPS

Treasury Inflation Protection Securities (TIPS), issued by the U.S. Treasury, are similar to other Treasury bonds in a number of respects:

• They are backed by the full faith and credit of the U.S. government, so they have no credit or default risk. Credit risk is the risk that the issuer's credit rating will be downgraded, which could decrease the bond's value, while default risk is the risk that the issuer will not be able to pay interest and/or principal. Keep in mind that the government guarantee relates only to the prompt payment of principal and interest and does not remove market risks.
• They are sold at Treasury auctions twice per year.
• Interest is paid semiannually.
• There is a very liquid secondary market.

The main difference between TIPS and other government bonds is that the bond's face value is adjusted periodically for inflation based on the increase in the Consumer Price Index for All Urban Consumers (CPI-U). The designated interest rate is determined at auction and does not change during the bond's life, but the principal is adjusted every six months. Thus, subsequent interest payments are based on the increased principal amount.

From a tax standpoint, interest income is subject to federal income taxes, but not state or local income taxes. Also, any increases in the bond's principal value is subject to federal income taxes in the year the adjustment is made, even though the funds aren't received until the bond matures. However, if the TIPS is held in a tax-advantaged account, such as a 401(k) plan or individual retirement account, income taxes are not paid until the funds are withdrawn.

To decide whether TIPS are a better alternative than other Treasury securities, calculate the difference between the yield on a 10-year TIPS and a 10-year Treasury security. If inflation is higher than the difference, the TIPS will have a higher yield than the other Treasury security. However, if inflation is lower than the difference, the other Treasury security will have a higher yield than the TIPS.

What happens if we enter a period of deflation? Then your principal will decrease so that your interest payments will also decrease over time. However, when the bond matures, you will still receive the full principal value.