What it means
With a TIPS bond, the face value is adjusted regularly using a consumer price index. The bond pays a fixed rate of interest, set when it is first sold, and that rate is applied to the adjusted face value.
If prices go up, the face value rises and so does each interest payment. Interest is paid every six months.
At maturity, the investor receives the adjusted principal, or the original principal if that is higher, so the bond has a built-in floor against deflation. This is a feature that ordinary index-linked arrangements do not always offer.
The tax treatment surprises many first-time buyers. In a taxable account, the yearly rise in the face value is usually treated as income in the year it happens, even though the investor does not receive the cash until the bond matures or is sold.
This is sometimes called phantom income, and it is why many people hold these bonds in tax-advantaged retirement accounts. The market price of a TIPS bond moves with real interest rates, which are interest rates after allowing for inflation.
If real rates rise, prices of existing bonds fall, even if inflation is high. An investor who holds to maturity avoids this, but one who sells early may suffer a loss.
The bonds also reveal what the market expects. The gap between the yield on an ordinary Treasury and the real yield on a TIPS of the same maturity is the breakeven inflation rate.
Economists and central bankers watch this figure as a rough gauge of inflation expectations. Buyers can hold the bonds directly or through funds.
Funds spread the risk across many issues but charge a fee and do not have a fixed maturity date, so their value can move up and down with the market.
In practice
Real-world examples.
Example
A 55-year-old saver wants to protect part of her retirement fund from rising prices. She buys a ten-year inflation-protected bond in her retirement account. Over the decade her principal grows with the index, so the bond's real value is preserved. She plans to reinvest the proceeds at maturity.
Example
A university endowment holds a mix of inflation-protected and ordinary bonds. The finance committee compares their yields to estimate the market's inflation expectation. If the breakeven rate is lower than the committee's own forecast, it buys more of the protected bonds. The committee reviews the decision each quarter.
Example
A taxable investor buys one of these bonds and is surprised to see a tax bill on income she has not yet received. Her adviser explains the phantom income rule. She moves future purchases into a tax-advantaged account. She now keeps cash aside to cover the tax each year.
Formula
Calculation
Adjusted principal = Original principal x Index ratio, and Semi-annual interest = Adjusted principal x Coupon rate / 2
Suppose an investor owns $20,000 of a bond with a coupon rate of 1.5%, and the index ratio since issue has reached 1.10. The adjusted principal is 20,000 x 1.10 = $22,000.
Semi-annual interest is 22,000 x 0.015 / 2 = $165, so the annual interest is $330 instead of the $300 paid on the original principal. If deflation later reduced the index ratio to 0.95, the adjusted principal would be 20,000 x 0.95 = $19,000, but at maturity the investor would still receive the original $20,000.Case study
Seen in the real world.
Cobalt Foundation is a fictional charity with a $5,000,000 fund that pays out grants each year. Its board wanted the fund to keep its real value for 20 years.
The treasurer invested $1,000,000 in inflation-protected securities with a coupon rate of 1.0%. After five years, with the index ratio at 1.15, the adjusted principal was 1,000,000 x 1.15 = $1,150,000, and annual interest was 1,150,000 x 0.01 = $11,500.
In this illustrative case, the foundation noted that the rise in value offset the higher costs of the grants it funded. The treasurer kept the holding at about one fifth of the fund, because the starting yield was low and the board still wanted exposure to shares, which have historically offered higher long-term returns with more risk.
Watch out
Common mistakes.
- Believing the bond cannot lose money, when its market price falls if real interest rates rise and the investor sells early.
- Overlooking the tax on the yearly principal adjustment, when held in a taxable account.
- Assuming the coupon rate changes, when the coupon is fixed and it is the principal that is adjusted, which in turn changes the dollar amount of interest.
Questions
People also ask.
What does TIPS stand for?
It stands for Treasury Inflation-Protected Securities, issued by the US government.
Is the principal protected in deflation?
At maturity the investor receives at least the original principal, even if prices have fallen.
How often is interest paid?
It is paid every six months on the adjusted principal, so each payment can differ slightly from the one before.
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