Treasury Inflation Protected Securities (TIPS) Q&A
What are TIPS?
TIPS are notes and bonds issued by the U.S. Treasury. These securities have a fixed coupon (interest rate) and mature on a specified date in the future.
What two concepts are most important to the future investment performance of TIPS?
- inflation
- the "real" rate of return (i.e., the portion of the investment return that investors require above the inflation rate).
What is inflation?
Inflation is defined as an economic environment with rising prices. Inflation can erode consumers’ purchasing power by making goods more costly and can negatively impact the effect of your investment returns if the investment does not appreciate enough to keep up with inflation.
How do we track inflation?
In the U.S., the key economic bellwether for tracking inflation is the Consumer Price Index (C.P.I.), which is published monthly by the Federal Government Bureau of Labor Statistics.
What are real interest rates?
The real interest rate is the interest earned after inflation is taken into consideration. For example, if an investment earns a nominal interest rate of 5% and inflation is 3%, then the real interest rate earned on the investment is 2%.
What is a nominal interest rate?
The nominal rate is the actual interest rate paid on an investment. For example, consider a U.S. Savings bond with a stated interest rate of 5%. This rate is considered the nominal rate. It is expected (but not guaranteed) to compensate the holder of the savings bond for inflation plus an additional return (i.e. “real” yield).
How do TIPS work?
The U.S. Government issues a TIP bond with a face value of $1,000 per bond and a stated real interest rate. Twice a year, the government pays interest based on the real interest rate and increases the value of the bond based on the change in the CPI. If there is a drop in the CPI, the government will lower the price of the bond but will never lower the price below the face value of $1,000.
Example of how the principal or face value of a Treasury Inflation Protected Security adjusts with the change in inflation or Consumer Price Index:
| Year |
Face Value |
CPI |
Value Adjust |
New Value |
Real
Rate |
Interest Paid |
| 1 |
$1000.00 |
2.2% |
$22.00 |
$1022.00 |
3.5% |
$35.77 |
| 2 |
$1022.00 |
0.0% |
$0.00 |
$1022.00 |
3.5% |
$35.77 |
| 3 |
$1022.00 |
-0.4% |
$-$4.09 |
$1017.91 |
3.5% |
$35.63 |
In summary, the principal or face value of TIPS fluctuates with the change in the inflation rate but the principal value will never be less than original principal value at the time the U.S. Government issued the security.
Under what conditions could the value of TIPS decline?
Generally, two conditions could cause the value of TIPS to decline.
- A period of deflation in the U.S. While the face value of a TIPS bond will never fall below $1,000, should the U.S. experience deflation (declining prices) after a period of inflation (rising prices), the face value could decline until it reaches $1,000. As demonstrated in the table above, prices declined in year 3. Accordingly, the face value of the bond fell in value based on the decline of the CPI for that year.
- Investor real interest rate expectations rise. At the time of purchase, one can calculate the real interest rate expectation priced into the value of the bond. Market forces set real interest rates based on supply and demand. Market dynamics are constantly changing and if supply and demand patterns change in a manner that results in an increase of real interest rate expectations, the price of a TIPS bond will decline.
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