Treasury Inflation-Protected Securities (TIPS) - dummies

Treasury Inflation-Protected Securities (TIPS)

By Russell Wild

Like the I bonds, Treasury Inflation-Protected Securities (TIPS), introduced in 1997, receive both interest and a twice-yearly kick up of principal for inflation. As with interest on other Treasury securities, interest on TIPS is free from state and local income taxes. Federal income tax, however, must be coughed up each year on both the interest payments and the growth in principal.

TIPS, unlike I bonds, are transferable. You can buy TIPS directly from the Treasury or through a broker. They are currently being issued with terms of 5, 10, and 30 years, although plenty of 20-year term TIPS are in circulation. The minimum investment is $100.

One of the sweet things about TIPS is that if inflation goes on a rampage, your principal moves north right along with it. If deflation, a lowering of prices, occurs — though it hasn’t since the 1930s — you won’t get any inflation adjustment, but you won’t get a deflation adjustment, either. You’ll get back at least the face value of the bond.

TIPS sound great, and in many ways they are. Be aware though, that the coupon rate on TIPS varies with market conditions and tends to be minimal — perhaps a couple of percentage points . . . or less. If inflation is calmer than expected moving into the future, you will almost certainly do better with traditional Treasuries. If inflation turns out to be higher than expected, your TIPS will be the stars of your fixed-income portfolio.

Also remember that TIPS with longer maturities can be quite volatile, even more so than other bonds. But, the returns for TIPs in past years have been higher than for nominal bonds, as well.

Keep in mind that TIPS are designed to keep you even with inflation, and they may do just that, but there is no guarantee. We may, for example, experience an inflation rate of 5 percent over the course of the next year. In that case, your $1,000 invested in TIPS will get you $50 from Uncle Sam.

On that score, you have your guarantee. But if investor sentiment turns away from TIPS, your principal may potentially drop by $50 or even more. So as you can see, TIPS are not manna from heaven.

Over the very long haul, one would fully expect the return on TIPS to be roughly the same as that on other similar-maturity Treasuries. But on a year-to-year basis, the two kinds of bonds will flip-flop. Flip-flopping — another word for diversification — is a good thing!

Generally about one-quarter of your bond portfolio should be devoted to inflation-protected securities. Less if you have a portfolio with lots of stocks (and, perhaps, commodities and real estate), as these have a good track record of keeping up with inflation.