Example of TIPS
The best way to understand how TIPS work is by example. TIPS pay interest semi-annually, but for the purposes of simplicity, the following looks at how the value of the bond changes in each calendar year. Suppose the Treasury issues an inflation-protected security with a $1,000 face value and a 3% coupon. In the first year, the investor receives $30 in two semi-annual payments. That year, the CPI increases by 4%. As a result, the face value adjusts upward to $1,040. In year two, the investor receives the same 3% coupon, but this time it’s based on the new, adjusted face value of $1,040. The result: instead of receiving an interest payment of $30, the investor receives interest of $31.20 (.03 times $1,040). In year three, inflation drops to 2%. The face value rises from $1,040 to $1060.80, and the investor receives interest of $31.82. This process continues until the bond matures. In this way, the TIPS’ payout consists of two parts: the increase in CPI and the “real yield,” that is, the yield above inflation. Once the bonds mature, investors receive either the adjusted, higher principal or their original investment, whichever is greater. As a result, investors cannot ever receive less than the face value of the bond, even in the rare case of deflation (falling prices).
Price Fluctuation Risks
Investing in TIPS may seem very compelling at first glance, but investors should consider three issues: TIPS are also highly sensitive to changes in prevailing interest rates. As a result, you could lose money if you were to sell a TIPS prior to its maturity. In that case, the loss of principal could far outweigh the benefit of inflation protection. If you intend to hold the bond until maturity, however, that isn’t an issue. Principal fluctuations are much more likely to be an issue if you own a mutual fund or exchange-traded fund (ETF) that invests in TIPS. In that case, rising interest rates will lead to a substantial decline in the value of the fund’s share price. Unlike an individual bond, mutual funds have no set maturity dates, so you have no guarantee of having the full value of your principal returned.
