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?
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:
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.
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