Treasury Inflation Protected Securities

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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]

Note: I Savings Bonds (I Bonds) also provide inflation protection. I Bonds are considered alternatives to TIPS. See I Bonds vs TIPS for similarities and differences between the two instruments.


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 

   $1,000 * 1.035 * 2% / 2 = $10.35

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

   $1,000 * 1.050 * 2% / 2 = $10.50

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 

   $1,000 * 0.985 * 2% / 2 = $9.85

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:

Mutual Fund

ETF

Tax Considerations

TIPS are not tax efficient. Both the inflation adjustment to principal and the interest payments are taxable as ordinary income for federal income tax. They are tax exempt for state and local income tax. It is often suggested that TIPS be held in a tax deferred or tax free account. If you must hold inflation indexed bonds in a taxable account, you may also consider I Savings Bonds.

If you hold individual TIPS in a taxable account, both the inflation adjustment to principal and the interest payments are taxable as ordinary income for federal income tax, although the bonds do not pay out the inflation adjustment to principal until the maturity date. This problem of paying taxes on income not received until a future date is often referred to as the "phantom income" problem. You must figure out how to report taxable income on your own using the 1099 forms you receive from TreasuryDirect or your brokerage firm.

If you hold TIPS through a mutual fund or ETF in a taxable account, the mutual fund or ETF will figure out and distribute the taxable income to you as dividends. Tax reporting is similar to other Treasury bond funds. [6]

Current and Historical Yield and Pricing Data

See also


References

  1. ↑ Treasury Direct: TIPS In Depth
  2. ↑ Treasury Direct: TIPS Rates & Terms
  3. ↑ TIAA-CREF: Inflation-Linked Bonds: Powerful Portfolio Diversifier
  4. ↑ Treasury Direct: Auctions In Depth
  5. ↑ An example of dividend distribution variance can be seen in the early 2009 distributions from the Vanguard Inflation-Protected Securities Fund. The semiannual report contains the following explanation: "Why the fund skipped a dividend: The income distributions from Vanguard Inflation-Protected Securities Fund are based on the sum of two factors. One is the real yield at which the fund securities were purchased (the “real purchased yield”). The other is the inflation adjustment to the value of these holdings, which is based on monthly changes in the Consumer Price Index. A rise in the index (inflation) increases the principal value of those holdings. Together with the “real purchased yield,” this upward adjustment is distributed as income, as required by the Internal Revenue Service. A decline (deflation) reduces the principal value, partially or fully offsetting the real yield. ... [L]ate 2008 was a period of significantly falling prices, or deflation. The inflation-related adjustments to the value of inflation-indexed securites are made with a two-month lag, so the significant deflation experienced in late 2008 offset all of (a bit more than, in fact) the fund’s “real purchased yield” accrued in the first half of 2009. The inflation rate has since crept into positive territory." [source: Vanguard Inflation-Protected Securities Fund 2009 Semiannual Report, p.5.] For a complete historical breakdown of the fund's distributions see Important information about Vanguard Inflation-Protected Securities Fund Investor Shares distributions
  6. ↑ Treasury Direct: TIPS: Tax Considerations

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