TIPS bonds adjust for inflation

This article was provided by Timothy M. Reese, senior vice president of investments with A.G. Edwards & Sons Inc.

An investment that keeps pace with inflation, earns interest and enjoys the backing of the full faith and credit of the United States government seems almost too good to be true, but such an investment does exist. Treasury Inflation Protection Securities, or TIPS as they are more commonly known, were introduced by the U.S. Treasury in 1997 and have risen in popularity as investors have fled the fluctuating equity markets and sought refuge in bonds.

Setting TIPS apart from other Treasury securities is that the value of the bond's principal, or face value, is pegged to the rate of inflation, or generally speaking the rise in the price of goods and services. Adjusted annually, the principal moves in accordance with the inflation rate, meaning when your bond reaches maturity, you receive the adjusted amount.

To give you a better understanding of how TIPS work let's look at an example. Note that this example is for illustrative purposes only and does not reflect the performance of any specific investment. Additional costs involved with investing were not included in the example, and past performance does not guarantee future results.

Say you purchased TIPS with a face value of $1,000, and at the end of the year, the rate of inflation was 3 percent. Your TIPS would be adjusted to reflect the 3 percent rate of inflation, or $30, giving it a face value of $1,030 for the next year, because it is adjusted on an annual basis.

Like other bonds, TIPS owners also receive interest payments twice a year. So, using the example above, not only do you receive a $30 increase in the principal value of your TIPS, but interest payments for the next year will be based on the new amounts. Let's take a look at how this works. When you purchase your TIPS, there is a coupon rate or a fixed rate of interest that you are paid for the life of the bond. Using the above example, you pay $1,000 for the TIPS and it has a coupon of 4 percent, so you receive 4 percent of the principal value yearly until the bond matures.

For the first year, the face value is $1,000, so you would receive two payments of $20, or 2 percent. This would bring your total interest payment to $40, or 4 percent annually.

After the first year, using the above example, your TIPS is adjusted for inflation to $1,030, reflecting the 3 percent increase due to inflation. You still receive an interest payment of 4 percent, but instead of receiving 4 percent of $1,000, you now receive 4 percent of $1,030. So you would receive two payments of $20.60, for a total of $41.20.

While this might not seem like a lot of money, it's important to keep in mind that the principal value will continue to increase annually as long as there's inflation.

Also, when your TIPS reaches maturity, you receive the full inflation-adjusted principal value of the bond. The interest income you earn on a TIPS is federally taxable, but it is exempt from state and local taxes. Any principal adjustment amount must be taken into account when filing your taxes. Therefore, TIPS may be most suitable for tax-deferred accounts.

While you will never receive less than the face value of TIPS at maturity, these securities are not completely risk-free. The principal of this type of bond is susceptible to deflation, or a decline in the price of goods and services. Deflation is the opposite of inflation, so instead of the principal value of your bond increasing, deflation would cause it to decline, meaning you would receive lower semi-annual interest payments.

It is important to remember that the principal amount represents the amount you can expect to receive at maturity, not the current market value. Like other bonds, TIPS prices rise and fall depending on whether prevailing interest rates fall or rise. TIPS are sometimes less liquid than normal Treasuries, and may be most suitable for investors who want to buy and hold until maturity, particularly in qualified accounts.

Like other bonds, TIPS are issued in varying maturities and denominations and could be a good security to consider when searching for fixed-income investments for your portfolio. Talk with your financial consultant about other characteristics of these securities and how they may fit into your asset allocation.