Treasury Inflation Protected Securities
Treasury Inflation Protected Securities or TIPS for short are debt instruments that are issued by the U.S. government. TIPS are indexed with the Consumer Price Index (CPI), and adjust accordingly to the inflation rate presented in the CPI.
Treasury Inflation-Protected Securities (TIPS) Explained
Treasury TIPS means that the security will adjust for inflation or deflation on whether the CPI increases or decreases. Because of this extra protection from inflation rates, TIPS owners are forced to pay more in taxes, a major disadvantage, when the security matures or it is sold. Treasury tips are normally sold with 5, 10, or 30 year maturities in denominations of $1,000 or more.
Treasury Inflation Protected Securities (TIPS) Example
Timmy has just invested in a TIPS note which has a 4% rate of return and a 10 year maturity. The following results are how an inflation protected security react to inflation and the market.
If interest rates rise by 1% in the first year then the principal would change to $1,010 (1,000 * 1.01). Thus the coupon rate would be calculated by taking 4% * $1,010 which equals a coupon payment of $40.40.
If the interest rates were to rise again by 2% then the new principal would change to $1,020 ($1,000 * 1.02), and the coupon payment would be 4% * $1,020 which equals $40.8.
Note: The new coupon payment and interest will change in the same manner no matter if deflation or inflation occurs.
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