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FINANCIAL TOOL
Treasury Inflation Protected Securities (TIPS)

There are plenty of ways to stay ahead of inflation over the long run. Some work best in the short-term. Others are more effective over the long-term.

As with virtually all things investment-related:

More short-term risk = more long-term potential reward

Less short-term risk = less long-term potential reward

Treasury Inflation Protected Securities fall under the latter. These are very high-quality investments, backed by the full faith and credit of the US government.

They won’t make you rich, but they will generally keep your money from losing purchasing power.

Here’s how they benefit you.

• The principal value of TIPS adjusts with the Consumer Price Index (CPI), increasing with inflation. They are issued in 5-year, 10-year and 30-year increments. But don’t forget that you can buy them for about any timeframe in-between in the secondary market.
• In addition to keeping pace with inflation, they also make semi-annual interest payments to you—a fixed percentage of the inflation-adjusted principal value.
• At maturity, the owner is repaid the higher of 1.) the principal value (adjusted upward if inflation has occurred) or 2.) the face value at which the TIPS were first issued.

Here’s an example of this in action.

Imagine a TIPS which you bought for $100, but inflation of 10% has taken place over the last two years according to the CPI. Now the adjusted principal of the TIPS is $110 ($100 × 1.10). If it was paying a 3% interest rate on $100 at the beginning, it is now paying 3% on $110, so the dollar amount of your interest payments has also increased.

The benefit that TIPS have over other types of bonds is that other bonds don’t necessarily keep up with inflation, especially if inflation starts to accelerate unexpectedly.

The risks of TIPS are these:

• In rare cases of deflation, the principal of TIPS may decrease, reducing future interest payments. At maturity, however, TIPS will pay at least the original face value.
• They pay lower interest than other types of Treasuries because of their added benefit of a rising principal value based on CPI. Return equals interest plus rising principal.
• Like other bonds, TIPS can lose market value if interest rates rise, meaning you may receive less than face value if selling before maturity.

Why own TIPS?

• If you have a short-term goal for the money in the next 1-5 years, holding a TIPS to maturity over that time period can help protect against loss of purchasing power.
• If you simply want to maintain purchasing power over any time period, without the need or desire to make beyond that.
• If you want to reduce overall volatility of a larger portfolio that includes more risky assets (such as stocks).
• If you want greater likelihood of earning higher than a money market account rate at the bank over time for a portion of your savings, such as a part of your emergency fund or your occasional expense fund.