TIPS are Treasury Inflation Protected Securities, and are issued by the US Treasury as a security whose primary objective is to protect you against inflation.
TIPS are bonds issued by the US Treasury, and therefore: one of the safest investments around. Since it is so – risk – free – the returns on TIPS is also lesser when compared with other securities.
TIPS is a unique product which is linked to inflation using the – CPI Inflation number.
How does TIPS work?
You can buy TIPS from TreasuryDirect.Gov or through brokers and bankers. TIPS are issued for a period of – 5, 10 or 20 years, and offered in multiples of 100.
How is the Price of TIPS determined?
The price which you pay to buy TIPS during the auction is determined based on the YTM and the Coupon Interest Rate. After an auction is concluded the Treasury announces the results of the auction, which is the price – the TIPS will be sold at.
TIPS pay out interest at every six months. This interest depends on two factors:
- Rate of Interest: The Interest Rate is predetermined during the auction.
- Principal: The principal amount is adjusted based on the inflation number – CPI.
There is an Index which is used as reference to adjust the Principal based on Inflation. The index number corresponding to the CPI number on a particular date is multiplied with the principal amount to arrive at the adjusted Principal. This adjusted Principal is then used to calculate the interest rate and pay out the semi-annual interest.
So, the principal varies, and not the interest rate. This is the opposite of what most people are used to in their loans, where the principal is fixed but the interest rate varies.
At maturity of TIPS – you get higher of the indexed principal back or initial investment back.
Best Way to Buy and Sell TIPS
You can buy TIPS directly through the TreasuryDirect.gov or through a broker. If you are buying through a broker then you will be charged a transaction fee, which is usually in the vicinity of $20 or so. Buying directly doesn’t involve this charge.