The best way to understand how TIPS work is to look at an example. Keep in mind that TIPS pay interest semiannually, but for the purposes of simplicity we’ll just look at how the value of the bond changes in each calendar year.
Say the Treasury issues an inflation-protected security with a $1,000 face value and a 3% coupon. In the first year, the investor will receive $30 in two semiannual payments. That year, the CPI increases by 4%. As a result, the face value is adjusted upward to $1040. In Year 2, the investor receives the same 3% coupon but this time it’s based on the new, adjusted face value of $1040.
The result: instead of receiving interest $30, the investor receives interest of $31.20 (.03 times $1040). In Year 3, inflation is only 2%. The face value rises from $1040 to $1060.80, and the interest is $31.82.
This process continues until the bond matures. In this way, TIPS’ payout is made up of two parts – the increase in CPI and the “real yield,” or in other words, the yield above inflation .
Once the bonds mature, investors receive either the adjusted (higher) principal or their original investment, whichever is greater.
Continue Reading Below
As a result, investors cannot receive less than the face value of the bond even in the rare case of deflation (falling prices).
No Free Lunches
TIPS may seem very compelling at first
glance, but there are three issues that investors need to keep in mind:
1) During the life of a TIPS bond, its principal will decline in periods of de flation, or falling CPI.
2) The increase in face value is taxed on a year-by-year basis, which not only eats into the element of inflation protection, but also creates a tax headache. Individual TIPS bonds are therefore more suitable for a non-taxable account.
3) While TIPS don’t carry credit risk – or the risk of a href="http://bonds.about.com/od/TheRisksofInvestinginBonds/a/Bond-Default-Definition-And-Explanation.htm">default by the issuer, in this case the U.S. government – their prices do fluctuate up and down in between their date of issuance and their date of maturity. What’s more, TIPS are highly sensitive to changes in prevailing interest rates. As a result, it’s possible to lose money if you sell a TIPS prior to its maturity – in which case the loss of principal may far outweigh the benefit of inflation protection. If you intend to hold the bond until maturity, however, that isn’t an issue.
Principal fluctuations are much more likely to be an issue if you own a mutual fund or exchange-traded fund (ETF) that invests in TIPS. In this case, rising rates will lead to a substantial decline in the value of the fund’s share price. Unlike an individual bond, there is no set maturity date on a fund, so there is no guarantee of having the full value of your principal returned.