Tips on TIPS (Treasury Inflation-Protected Securities)
by Gene Walden

(Excerpt from If Not Stocks, What? Chapter 6)

Safety and inflation-adjusted income

To attract investors during low interest environments, the federal government introduced a new type of Treasury security recently that increases in value and pay-out along with the rate of inflation. The new bonds, technically known as Treasury Inflation-Indexed Securities, are referred to as TIPS (an acronym for Treasury Inflation-Protected Securities). TIPS are designed to help you maintain the true worth of your investment regardless of the rate of inflation.

Like other Treasury securities, TIPS pay interest twice a year and are exempt from state and local taxes. They are issued in 10-year terms.

During times of inflation, TIPS not only pay a higher return, they also increase in value. The principal increases, so when they reach maturity, you would receive more money than you actually paid in initially.

Here is how TIPS work:

Using the Consumer Price Index as a guide, the value of the principal is adjusted to reflect the effects of inflation. A fixed interest rate is paid semi-annually on the adjusted amount. At maturity, if inflation has increased the value of the principal, the investor receives the higher value. If deflation has decreased the value, the investor nevertheless receives the original face amount of the security.

For instance, let’s say you invested $1,000 in a 10-year inflation-indexed note paying 3 percent interest. At mid-year, the Consumer Price Index indicates that inflation has been 1% during the first six months. Your principal is adjusted upward to $1,010 and your interest payment (one-half of 3%) is based on that figure. Your payment is $15.15. At the end of the year, the index indicates that inflation was 3 percent, which brings the value of your principal to $1,030. Your second interest payment is $15.45

($1,030 times 3% divided by 2).

Here are some other important tips on TIPS:

• The interest rate, which is set at auction, remains fixed throughout the term of the security.
• The principal amount of the security is adjusted for inflation, but the inflation-adjusted principal will not be paid until maturity.
• Semiannual interest payments are based on the inflation-adjusted principal at the time the interest is paid.
• The index for measuring the inflation rate is the non-seasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U), published monthly by the Bureau of Labor Statistics (BLS).
• The auction process uses a single-price auction method that is the same as that currently used for all of Treasury's marketable securities auctions.
• At maturity, the securities will be redeemed at the greater of their inflation-adjusted principal or par amount at original issue.

Although TIPS tend to pay a lower interest rate initially than T-bonds or notes, that could change over the term of the bond. Either way, the adjustable rate feature assures you that your TIPS will always outpace inflation.

Who should buy TIPS?

TIPS are geared to conservative investors interested in safety, income, tax savings, and a hedge against inflation. Aggressive investors might also be interesed in TIPS because they provide diversification for the portfolio.

Who should not buy U.S. Savings bonds?

TIPS would not be attractive to investors looking for capital appreciation or aggressive investors looking for a higher annual return.

Return

The initial rate of return offered by TIPS is somewhat lower than T-bonds and notes, but over the term of the TIPS bond, its return could exceed that of other Treasury securities. And, at the end of the term, the principal would be higher than the principal from other traditional Treasury securities, such as bonds and notes, that carry a fixed interest rate and a fixed principal. Because the TIPS principal grows with inflation, your principal at the end of the 10-year term could be significantly higher than it was at the beginning.

To adjust the TIPS principal, the government uses the Consumer Price Index as a guide. The value of the principal is adjusted to reflect the effects of inflation. The interest rate itself is fixed for the life of the bond, but that interest rate accounts for a higher actual payment each time the principal increases.

Specifically, each interest payment (two per year) is calculated by multiplying the inflation-indexed principal by one-half the fixed interest rate determined at auction when the bond was issued.

For example, let’s say you’re holding a $1,000 TIPS with a 4 percent interest rate, and inflation is up 2 percent. You would multiply the $1,000 principal by 2 percent, which equals $20, and add that $20 to the principal, giving you a principal of $1,020. Then multiply that times your 4 percent fixed annual interest rate, which equals $40.80. Since you receive half of your interest every six months, you would divide that annualized sum in half, giving you a semi-annual payment of $20.40 cents.

TIPS are one of the safest investments every conceived. Not only are they essentially free from default since they are backed by the full faith and credit of the federal government, they are also insulated against the effects of inflation. You are virtually assured that the value of your investment will not decline. Even during times of deflation, TIPS owners are guaranteed that their principal would not fall any lower than their original investment.

Upside

In addition to their safety and inflation protection, TIPS offer several other excellent benefits:

• Tax savings. Earnings are exempt from state and local taxes.
• Non-callable. TIPS are not callable, which means the Treasury cannot redeem them before maturity—unlike bonds issued by many corporations and municipalities.
• Liquidity. You can sell TIPS on the secondary market. If you don’t want to hold them through maturity, it’s easy to find a buyer.

• Easy to buy. TIPS are easy to buy and can be purchased through your bank, your broker, or the U.S. Treasury.

Downside

The downside to TIPS is that they pay a fairly low interest rate compared with corporate bonds and U.S. Treasury bonds. But the inflation-protection feature eliminates some of the concern you would normally have with fixed income investments. With other bonds, bond values drop as interest rates rise. But with TIPS, your semi-annual interest payment can increase significantly during the term of the bond. Rising inflation and rising interest rates often go together, so as market interest rates rise, there is a good chance that your TIPS returns would increase, as well.

How to Buy TIPS

Like other Treasury securities, TIPS are available in denominations of $1,000 and up, with terms of 10 years or 30 years. You can purchase TIPS through a bank, a broker, or—for those who prefer to pay no commission—directly from the U.S. Treasury. To buy from the Treasury, you would go directly through a Federal Reserve branch or the Bureau of Public Debt (1300 C St., S.W., Washington, DC 20239).

In order to buy directly from the Fed, you need to put in a "noncompetitive bid" at a the Treasury’s quarterly auction (they occur in February, May, August, and November), which means you are willing to pay the average rate for the securities you want. Otherwise you can buy a Treasury security through a regular bank or brokerage firm for a fee of about $50. They can also be bought and sold on the secondary bond market.

You can also buy TIPS through the U.S. Treasury’s Web site, www.treasurydirect.gov. You can go to the site, click on the section for "Treasury Bills, Notes and Bonds," and follow the instructions. You’ll be able to buy TIPS online, directly from the U.S. Treasury without paying a commission.

Biggest Concerns

TIPS are very simple, predictable investments. Since they are adjusted for inflation, you don’t have to worry about inflation drain, and since they are backed by the federal government, there’s no concern about loss of capital investment. The biggest concern would be deflation. In a period of deflation, the return could decline, although the principal is guaranteed not to drop below the initial par value of the investment. In other words, you have almost nothing to worry about with TIPS.

Timing

The best time to buy TIPS would be during a period of rising inflation. Since the principal and interest payment rises as inflation rises, TIPS would be more alluring during periods of high inflation than traditional fixed rate securities, which pay the same interest rate through maturity—which can be for up to 30 years.

By contrast, the worst time to buy TIPS is when inflation is low because your rate of return would be fairly low relative to other fixed income investments. In the unlikely event of deflation, your TIPS principal could decline, although it could drop no lower than the original par value of the TIPS.

Monitoring Your TIPS

It is not easy to find information about TIPS rates and prices, but you can find up-to-date information at the U.S. Treasury Web site, www.treasurydirect.gov or at www.publicdebt.treas.gov. You’ll also be kept up-to-date on the size of your inflation-adjusted principal and your interest payment in the statement that comes with your semi-annual interest check.

Asset Allocation

The amount of money you allocate toward TIPS would depend on your tax situation, your financial situation, your investment goals and your threshold for risk.

Conservative investors who are more concerned with preservation of spending power than they are with growth might want to invest 20 to 60 percent of their assets in TIPS or a combination of TIPS and T-Bonds or notes under normal economic conditions. You might want to lighten the weighting of Treasuries in the portfolio during periods of low interest rates, and increase the weighting during periods of high interest.

Aggressive investors looking for long-term growth would probably want to limit their investment in TIPS, particularly in times of low inflation. However, an allocation of 5 to 20 percent of assets in TIPS or other Treasury securities even for aggressive investors would help provide balance and diversification, and could buoy the portfolio when stocks are down.

Special Considerations

One of the great benefits of TIPS is that their value or principal increases in step with inflation. But that can complicate your tax situation. Every time the principal increases, that’s considered a taxable gain. Although the bonds are exempt from state and local taxes, those gains are subject to federal income taxes. If your principal increases, you are subject to taxes on those gains each year—even though you wouldn’t receive the gains from your inflation-adjusted principal until the security matures.