Treasury Inflation-Protected Securities (TIPS)

Treasury securities whose principal rises and falls with the Consumer Price Index, so their interest and final payout keep pace with inflation.

What it means

TIPS pay a fixed interest rate every six months, but the rate is applied to a principal amount that is adjusted for inflation as measured by the Consumer Price Index. When prices rise, the principal and each interest payment grow; during deflation they shrink. At maturity the investor receives the adjusted principal or the original principal, whichever is greater.

Like other Treasuries, TIPS have very low default risk, but their market prices change with real interest rates, so selling before maturity can produce a loss. Interest and inflation adjustments are exempt from state and local tax but subject to federal tax. The yearly increase in principal is taxable in the year it occurs even though it is not paid until maturity, sometimes called phantom income, which is why many people hold TIPS in tax-advantaged accounts.

Example

Suppose someone holds $1,000 of TIPS with a 1% coupon and inflation runs 2% for the year. The principal adjusts to $1,020, and a full year of interest is 1% of that, or $10.20. The $20 increase is federally taxable that year.

How it’s used

Protecting part of a portfolio against unexpected inflation
Funding future spending, such as retirement income, in real terms
Diversifying bond holdings

Strengths and weaknesses

Strengths

Principal and interest keep pace with CPI inflation
Very low default risk
Original principal is protected at maturity

Weaknesses

Federal tax due on inflation adjustments not yet received
Market value can fall when real interest rates rise
Coupon rates are often lower than regular Treasuries

Educational information only, not financial, tax or legal advice. Rules, limits and rates change; check the IRS, your lender or plan, or a qualified professional before acting.