Treasury Inflation Protected Security

Introduction
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.

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.

How Does It Work
After a TIPS note is issued, its principal is adjusted daily using the Consumer Price Index (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 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. You can obtain the current and historical published Index Ratios for every TIPS bond from the Treasury Department.

Like regular bonds, a TIPS note also pays interest twice a year. The interest paid is calculated by multiplying the adjusted principal by one-half the interest rate. For example, if a TIPS note 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 note will pay interest of

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

When there is continued inflation, the TIPS principal goes up with inflation. The interest payments also go up with inflation.

Role in a Portfolio
TIPS belong to the Bonds category. Its 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.

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, the interest rate will be determined by the auction. If it's a re-opening, the interest rate is already known. The auction will determine the price which in turn determines the yield.

After the announcement date but before the auction cutoff time, retail investors can place auction orders through TreasuryDirect or through a broker 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 May 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.

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.

On Secondary Market
You can also buy TIPS at any time on the secondary market. As of May 2008, Fidelity and Schwab charge no fee for TIPS bought on the secondary market if the order is placed online. Vanguard Brokerage Services charges minimum $40 for online orders.

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. Popular choices include:

Mutual Fund ETF
 * Vanguard Inflation-Protected Securities Fund (VIPSX) - Expense Ratio = 0.20%
 * iShares Lehman U.S. Treasury Inflation Protected Securities Bond Fund (TIP) - Expense Ratio = 0.20%
 * SPDR Barclays Capital TIPS ETF (IPE) - Expense Ratio = 0.1845%