Treasury Inflation-Protected Securities (TIPS)
Now that you understand standard Treasury securities, TIPS add an important twist: their principal adjusts with inflation, protecting investors from purchasing power erosion.
TIPS Overview
| Feature | Detail |
|---|---|
| Maturities | 5, 10, and 30 years |
| Minimum purchase | $100, in $100 increments |
| Interest method | Fixed coupon rate; pays interest semiannually on the adjusted principal |
| Inflation index | Non-seasonally adjusted Consumer Price Index for All Urban Consumers (CPI-U) |
| Issued form | Book-entry only |
| Tax treatment | Interest and annual principal adjustment subject to federal income tax; exempt from state and local tax |
How TIPS Work
The key mechanism is that the principal (par value) adjusts with changes in the CPI-U:
- When inflation rises → principal increases
- When deflation occurs → principal decreases
The coupon rate stays fixed, but because it is applied to the adjusted principal, the dollar amount of each interest payment changes:
- Rising inflation → larger principal → higher interest payments (same rate on a bigger base)
- Deflation → smaller principal → lower interest payments (same rate on a smaller base)
Example:
- $1,000 TIPS with a 2% coupon
- If CPI-U increases 3% in year one → adjusted principal = $1,030
- Semiannual interest = 2% / 2 x $1,030 = $10.30 (instead of $10.00 on the original par)
Exam Tip: Gotchas
- The TIPS coupon rate is FIXED. It does not adjust with inflation. Only the principal adjusts, which changes the dollar amount of each interest payment.
The Deflation Floor
At maturity, the investor receives the greater of:
- The inflation-adjusted principal, OR
- The original par value
This deflation floor ensures that even if cumulative deflation has reduced the adjusted principal below face value, the investor gets back at least the original amount invested.
Exam Tip: Gotchas
- The deflation floor protects the principal at maturity, not the interest payments during the life of the bond. If deflation reduces the adjusted principal, semiannual interest payments will decrease accordingly. The floor only guarantees the original par value at maturity.
TIPS Tax Treatment: Phantom Income
This is the most frequently tested TIPS concept on the Series 7.
- The annual increase in principal due to inflation is taxable as ordinary income in the year of the adjustment
- The investor does not receive the principal increase until maturity
- This creates phantom income: taxable income with no corresponding cash flow
Think of it this way: The IRS taxes you on the principal increase each year, even though you will not see that money until the bond matures. You owe tax on income you have not actually received yet. That is why TIPS are often held in tax-deferred accounts (IRAs, 401(k)s), where annual taxes on phantom income can be avoided.
Exam Tip: Gotchas
- Phantom income is taxed as ordinary income, not capital gains. The annual inflation adjustment to principal is taxable in the year it occurs, even though the investor does not receive the cash until maturity.
- Because of phantom income, TIPS are best suited for tax-deferred accounts.