TIPS bonds offer low-risk investment opportunities with low interest rates, protected from inflation by the US government. Interest rates are locked in for the life of the bond, but principal amounts increase during inflation and decrease during deflation. Semiannual distribution payments are taxable, but TIPS bonds can be actively sold at any time.
TIPS bonds represent low-risk investment opportunities that have low interest rates, but are protected from any inflation in the economy. This is because the United States government issues the bonds and guarantees at least the repayment of the original principal payment to the investor. While the interest rate on TIPS, or Treasury Inflation Protected Securities, bonds are locked in for the life of the bond, the principal amount increases during inflation and decreases during deflation. TIPS bond distributions are made twice a year based on interest on the principal amount, but the fact that these payments are taxable represents one of the shortcomings of this investment opportunity.
Investors often rely on bonds for a low-risk, low-reward investment opportunity that can provide diversity to any portfolio. Inflation within the economy can cause certain bonds to lose value or even lose money for the investor. TIPS bonds represent a remedy for this situation, since they actually grow in value with inflation and are protected by the government to prevent the investor from losing any part of their original investment.
Those who buy TIPS bonds buy them at an interest rate that is then locked in for the life of the bonds or until they are sold. Although the interest remains the same, distribution payments to the investor, which are made twice a year, can change due to the nature of the economy. When there is inflation within the economy, the principal of the bond goes up, and when there is deflation, the principal goes down. Interest is applied to wherever the principal is located at the time the distribution is paid.
When the bond matures, the investor is guaranteed the return of the original principal payment or the principal at maturity plus any accrued interest, whichever is greater. TIPS bonds can also be actively sold at any time, giving them an advantage over I bonds, which are also government-issued and inflation-protected. In the case of I bonds, they must be held for at least one year, and if they are redeemed before five years, a penalty is incurred.
Although TIPS bonds are tax-exempt, the semiannual distribution payments are subject to United States federal income tax. Additionally, any increase in principal due to inflation also represents taxable income. This can be problematic because investors do not have access to principal while holding the bond, which means they must pay taxes on income that is not actually in their possession, a concept known as phantom income. Since this is the case, many investors place these bonds in tax-deferred accounts.
Smart Asset.
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