As the Government continues to flood the economy with new money via QE1, QE2, Operation Twist and now Twist2, many investors are fearing a massive inflation may be just around the corner. And so they are looking for a sfe haven to protect their investments from the deluge they see coming. Therefore they are turning to Treasury Inflation Protected Securities, or “TIPS”. TIPS are considered an extremely low-risk investment as they have Government backing, are protected from the ravages of inflation and are less volatile than bonds and safer than stocks.
How Treasury Inflation Protected Securities (TIPS) Protect Against inflation
Over time even small levels of inflation can make a big difference in the purchasing power of your investment. So for long-term savers and investors, inflation can be a major enemy of your retirement fund. If your rate of return isn’t greater than the rate of inflation, then the real value of your investment (the inflation adjusted value) drops and, with it, your spending power. So even though it looks like you have more money, you can actually buy less with it.
Treasury Inflation Protected Securities (TIPS) adjust your investment value according to changes in the Consumer Price Index (CPI), i.e the inflation rate. So, when there is inflation, or a rise in the index, the principal increases and, with deflation, the principal decreases. But you are protected against long term deflation as well since, when a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.
TIPS are sold at auction several times a year with five, ten or 30 year maturities. The minimum purchase allowed under the scheme is $100.
How interest is paid on Treasury Inflation Protected Securities?
TIPS pay interest at a fixed rate every six months. But because your principal will be adjusted according to inflation or deflation, interest payments can vary in amount from one six-month period to the next. If inflation increases, then so will your interest payment and if there’s deflation, your interest payment will go down. Each interest payment is calculated by multiplying the adjusted principal by one-half the interest rate.
The relationship between TIPS and the CPI also has a direct bearing on the amount you are paid when your investment matures. But your investment is protected against deflation as, at the maturity of a TIPS, you get either the adjusted principal or your original investment, whichever is greater. So if you initially buy $500 in TIPS and prices of goods and services double over your term, your principal will be worth $1,000, but if prices fall, you’ll still get your $500.
The U.S. Treasury provides Treasury Inflation Protected Securities (TIPS) Inflation Index Ratios to allow you to easily calculate the change to principal resulting from changes in the Consumer Price Index.
Methods of buying TIPS
There are two choices when it comes to purchasing Treasury Inflation Protected Securities – you can buy them directly from the Treasury or through a broker.
If you choose to go with the direct option, you can buy online by setting up a TreasuryDirect account, with the interest rate you’ll get determined at the time of purchase. Typical rates tend to be around 2%.
Or, you can go through a bank or broker to buy shares in an Exchange Traded Fund (ETF).
A Treasury Inflation Protected Security ETF works by investing in a range of TIPs with different maturity dates and investment rates. Interest is paid out either monthly or quarterly depending on the fund you choose and your increase in principal will also be paid out monthly or quarterly without you having to wait until maturity.
But, because you could be investing in older accounts where increases in principal will have already been paid out, your investment could actually decrease with deflation and you will have to pay brokers’ commission fees.
Treasury Inflation Protected Securities (TIPS) and taxes
Your interest income and principal growth will be exempt from state and local income taxes but it will be subject to federal income taxes. While you’ll pay tax annually on your adjusted investment value, you won’t actually get your increased principal until your bond is redeemed at maturity, so it could be worth considering putting your TIPS into a tax deferred-account.
For More Information:
- Inflation Adjusted S&P 500 Earnings
- What are I bonds?
- What is Quantitative Easing?
- Sheltering Cash From Inflation
About The Author:
Liz Hands is a financial blogger who writes for currency-converter.com