Inflation-protected Treasury securities, also known as TIPS, offer protection against inflation and are purchased through public auctions or approved brokers. The principal increases with the Consumer Price Index (CPI), but yields are lower. Interest is exempt from state and local taxes but subject to federal income tax. These securities mature in 5, 10, and 20 years and can be held to maturity or sold before expiration.
An inflation-protected (TIP) Treasury security is a special type of note or bond that the United States Department of the Treasury uses to finance public debt. At the same time, inflation-protected Treasury security offers investors protection against the up and down swings that come with inflation. These securities are also called inflation-indexed Treasury securities.
These securities are generally purchased in multiples of $100 United States Dollars (USD) through public auctions from the Department of the Treasury. Offers can also be made through a government-approved bank, broker, or dealer. Treasury bond and treasury note auction dates are advertised in major newspapers and online news releases on the department’s website. Investors can also subscribe to email notifications.
Inflation is an increase in the cost of goods and services. As inflation rises, the base amount an investor deposits in an inflation-protected Treasury security, known as principal, increases simultaneously at the same rate as the Consumer Price Index (CPI). On the other hand, during deflationary periods, when prices are falling, the principal also falls.
The CPI is a weighted average of the prices of a basket of consumer goods and services. It is used to measure increases and decreases in the cost of living for consumers. Although the CPI experiences some volatility over time, an inflation-protected Treasury security is considered a safe investment because principal is not compromised when the CPI falls. If deflationary pressures cause the interest-adjusted principal to fall below the original investment amount, the original principal is paid in full at maturity.
But there is a trade-off for that peace of mind. Treasury Inflation Protected Securities (TIPS) offer a lower yield. The US Department of the Treasury provides an online TIPS Inflation Indices page to help investors calculate changes in principal, based on changes in the CPI.
Inflation-protected Treasury securities pay interest every six months at a fixed rate and pay principal to the investor at maturity. They mature in terms of 5 years, 10 years and 20 years. For example, a 10-year TIPS note might have a semiannual interest rate of 4 percent, or 3.875 percent, with yields of 4.075 percent, or 3.937 percent.
Interest on an inflation-protected Treasury security is exempt from state and local income taxes, but is subject to federal income tax. Federal income tax on interest payments is applied to the year in which the interest is received. With respect to capital growth, federal income tax is applied in the year in which it occurs.
An inflation-protected Treasury security can be held to maturity or sold before the expiration date. At maturity, the principal can be used to purchase another security. Investors do not have to take any special steps to redeem TIPS. The Treasury Department will automatically deposit the principal in a previously designated bank account.
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