Buying Treasury Inflation Protected Securities (TIPS)

Treasury Inflation Protected Securities (TIPS) bonds are among the safest potential investments on the market today. They are a combination of a basic Treasury bond and an inflation protected security. Similar to I-bonds, TIPS bonds have two separate factors determining the interest you will earn in a given year. However, the way the factors are measured differs with a TIPS bond when compared to a traditional I-bond.

Treasury I-Bonds

I-bonds are standard Treasury bonds with two interest rates. The first is a fixed rate guaranteed at the time the bond is purchased. The second rate is set based on the rate of inflation. This addresses one critical problem with many Treasury bonds. Since the interest rates on Treasury bonds are relatively low, high inflation rates can take a chunk out of earnings, particularly on long-term bonds. By setting this second rate equal to inflation, I-bonds offer a guarantee against loss. If inflation decreases, a phenomena called "deflation," the second interest rate can decrease. The result would be a dip below the primary interest rate that was quoted on the bond. However, I-bond interest rates will never dip below 0. Further, an investor is guaranteed to recover par value when the bond reaches maturity.

TIPS Bonds

TIPS bonds evolved after I-bonds. They work in a similar fashion, but the way inflation is accounted for is slightly different. The interest rate on the bond is fixed at the beginning of the contract, and this rate never adjusts. The underlying bond value, though, is adjusted semiannually to account for the effect of inflation. This means an investor will receive a different payment every six months, even though the interest rate remains constant. When the bond matures, the par value may be different from the par value when the bond was purchased. This means the investor is not guaranteed a straight, 100 percent recovery. However, in most markets, the recovery will be greater due to inflation. 

Benefits of TIPS Bonds

TIPS bonds have successfully countered the one element that made long-term Treasury bonds risky: inflation. On the whole, government bonds have been the safest form of investment. After all, the Treasury has a zero percent chance of bankruptcy. It can always simply print money in order to pay off debts. However, if the Treasury does this, inflation will go up. Even if the bond was repaid, the dollar figure could have been significantly compromised in value due to this inflation factor. With TIPS bonds, that element was removed.

Drawbacks of TIPS Bonds

For all their safety, TIPS bonds are understandably low-profit investments. Whenever an investor chooses the least risky option available, he or she should be prepared to compromise potential profits. TIPS bonds are best for long-term investments for which the individual wants absolute protection of the capital amount and only a moderate payment. For example, this is a good option for a retiree or a family saving for college education. The principal bond amount will never be compromised, and the investor will receive a little extra cash day to day in the meantime.

blog comments powered by Disqus