Treasury Inflation-Protected Securities

TIPS belong to this family. The SEC's investor material describes them as notes and bonds whose principal is adjusted based on changes in the Consumer Price Index. It states that they pay interest every six months and are issued with maturities of five, ten and thirty years. FINRA describes them in similar terms, as fixed interest securities issued with maturities of five, ten and thirty years.

The Treasury sells TIPS in the same way it sells its other marketable securities. The Treasury's glossary explains that an auction is how the Treasury sells Treasury bills, Treasury notes, Treasury bonds and TIPS. Securities issued or guaranteed by the United States are also exempt from the registration requirements of the Securities Act of 1933 under Section 3(a)(2) of that Act, which covers any security issued or guaranteed by the United States.

The Problem TIPS Are Meant to Address

FINRA defines inflation risk as the risk that the yield on a bond will not keep pace with purchasing power. The SEC's investor material makes a similar point, explaining that inflation reduces purchasing power, which is a risk for investors receiving a fixed rate of interest. The Treasury's glossary defines inflation as a rise in the general level of prices of goods and services in an economy over a period of time.

A hypothetical shows the problem. Suppose an investor owns a bond that pays fifty dollars of interest a year and repays one thousand dollars at maturity. Both amounts are fixed in dollars. If the general level of prices rises substantially over the life of the bond, fifty dollars and one thousand dollars will each buy fewer goods and services at the end than at the start. This illustration does not describe any actual security.

FINRA explains that TIPS shelter investors from inflation risk because their principal is adjusted for inflation based on changes in the Consumer Price Index for All Urban Consumers. The adjustment is the central feature of the security, and the rest of this entry builds on it.

What Is Being Measured

The index that Treasury uses is a specific one. The Treasury's glossary explains that the CPI-U, the Consumer Price Index for All Urban Consumers, is used to adjust the principal of a TIPS. The Treasury's regulations define the Consumer Price Index for this purpose as the monthly non-seasonally adjusted United States city average all items Consumer Price Index for All Urban Consumers, published by the Bureau of Labor Statistics.

Two details of that definition matter. The index is a measure of price changes for urban consumers as a group, and it is not a measure of the cost of living for any individual household. An investor whose own spending rises faster or slower than the index will not see the adjustment match their personal experience. And the index used is published monthly, so the adjustment reflects monthly data and not a continuous feed of prices.

How the Principal Is Adjusted

The Treasury's regulations set out the mechanics. They define the index ratio, for an inflation-protected security, as the reference Consumer Price Index of a particular date divided by the reference Consumer Price Index of the original issue date. The reference index is the index number applicable to a given date. The regulations then explain how reference index numbers are determined. The reference index for the first day of any calendar month is the Consumer Price Index for the third preceding calendar month. For example, the reference index for April 1 is based on the January index. For dates other than the first of a month, the regulations use linear interpolation between the reference index for that month and the reference index for the following month.

Two features follow from this. The first is the lag. Because the reference index for a month is the index for the third preceding month, the adjustment always trails the price level by a period of months. The second is the smoothing. Because the reference index for a day inside a month is interpolated, the index ratio changes gradually from day to day and not in a single step each month.

The adjusted principal is the original principal multiplied by the index ratio. If the index ratio is greater than one, the adjusted principal is greater than the original principal. If the index ratio is less than one, the adjusted principal is smaller.

A hypothetical shows the arithmetic. Suppose a TIPS with an original principal of one thousand dollars is issued when the reference index is 300, and some time later the reference index is 309. The index ratio is 309 divided by 300, which is 1.03, and the adjusted principal is one thousand and thirty dollars. If the reference index had instead fallen to 291, the index ratio would be 0.97 and the adjusted principal would be nine hundred and seventy dollars. These index numbers are chosen only for arithmetic and are not actual values.

How Interest Is Calculated

A TIPS pays a fixed interest rate, set when the security is issued, and the Treasury's regulations explain that each interest payment is calculated by multiplying one-half of the specified annual interest rate by the inflation-adjusted principal for the interest payment date. The Treasury's educational material for young savers makes the same point more simply. It explains that the changes in the principal affect the amount of interest an investor will be paid, because the rate is paid on the principal, so the interest paid will increase if the principal increases and decrease if the principal decreases.

Continuing the hypothetical, suppose the fixed annual rate is 1 percent. One-half of 1 percent of an adjusted principal of one thousand and thirty dollars is five dollars and fifteen cents for that six-month payment. If the adjusted principal were nine hundred and seventy dollars, one-half of 1 percent would be four dollars and eighty-five cents. The rate did not change in either case. The principal on which the rate is applied did.

This is the sense in which a TIPS offers inflation protection. The rate is fixed in advance, but the dollar amount of each payment is not. When prices rise, the principal rises and so does each interest payment. When prices fall, the opposite occurs.

How the Adjustment Builds Over Several Years

Because interest is calculated on the adjusted principal, the effect of inflation builds on itself. A hypothetical shows how. Suppose the index ratio rises by 3 percent a year for five years. The index ratio after five years is about 1.159, so an original principal of one thousand dollars has become an adjusted principal of about one thousand one hundred and fifty-nine dollars. With a fixed annual rate of 1 percent, the six-month interest payment at that point is about five dollars and eighty cents, compared with five dollars at the start. Neither number reflects an actual security or a forecast of inflation.

The same arithmetic works in reverse. If the index ratio were to fall below one for a time, the adjusted principal and the interest payments would be lower than at issue during that period. The floor in the payment at maturity limits the loss of principal at the end, but it does not restore the interest payments that were calculated on a lower adjusted principal along the way.

What the Investor Receives at Maturity

The payment at maturity includes a protection against deflation. The Treasury's educational material explains that, at the end of a TIPS' term, the investor receives either its original face value or the inflation-adjusted value, whichever amount is larger. FINRA's description is consistent. It explains that, at maturity, if the adjusted principal is greater than the face value, the investor receives the greater value.

Return to the hypothetical. If the index ratio at maturity is 1.20, the adjusted principal is one thousand two hundred dollars, and that is the amount the investor receives. If the index ratio at maturity is 0.97, the adjusted principal is nine hundred and seventy dollars, which is less than the original principal, and the investor receives the original face value of one thousand dollars instead.

The protection applies at maturity. During the life of the security, the adjusted principal can be lower than the original principal if the price level has fallen, and in that situation interest is calculated on the lower amount, as the example above shows. The floor on repayment is a feature of the payment at maturity and does not hold the adjusted principal at or above its original level at every point along the way.

TIPS Compared With Ordinary Treasury Notes and Bonds

The difference between a TIPS and an ordinary Treasury note or bond is easiest to see by comparing what is fixed in each. In an ordinary Treasury note or bond, the interest rate and the principal are both fixed in dollars, so the SEC's observation that inflation reduces purchasing power for an investor who receives a fixed rate of interest applies directly. In a TIPS, the interest rate is fixed but the principal is not, so the dollar amounts move.

Return to the hypothetical with an original principal of one thousand dollars and a fixed rate of 1 percent. If the index ratio rises to 1.03, a TIPS makes a six-month payment of five dollars and fifteen cents and has an adjusted principal of one thousand and thirty dollars. An ordinary security with the same principal and a comparable fixed rate would still make the same fixed payment and would still have the same principal, whatever happened to prices. The comparison does not say which security is the better purchase. That depends on how prices actually change and on the rates at which each security was issued, and the illustration makes no prediction about either.

The comparison also shows what the two securities share. Both are Treasury securities backed by the full faith and credit of the United States, both are sold at auction, and both are subject to the price movement that FINRA describes for bonds when interest rates change.

An Illustration of the Lag

The three-month lag can be shown with the example in the Treasury's regulations. The reference index for April 1 is based on the January index. Suppose, as a hypothetical, that prices rise sharply in February. The February increase does not affect the reference index for April 1. Because dates inside April are interpolated between the April 1 reference index and the May 1 reference index, the February increase begins to enter the reference index during April and is fully reflected on May 1, when the index for the third preceding month is February. The adjusted principal therefore catches up with a price change a few months after the change takes place, and the interpolation spreads the final step of that catch-up over the days of a month. This illustration does not describe actual index values.

How TIPS Are Taxed

The tax treatment of TIPS has a feature that surprises many investors. The Treasury explains that the semiannual interest payments and the inflation adjustments that increase the principal are subject to federal tax in the year in which they occur, but are exempt from state and local income taxes. The SEC's investor glossary makes the same distinction for Treasury securities generally, stating that the income may be exempt from state and local taxes but not from federal taxes.

The significance is that tax can be due on an increase in principal before the investor receives the cash. The increase in adjusted principal is not paid out until maturity or until the security is sold. IRS Publication 550 addresses the rule in its discussion of original issue discount. It states that an investor must report as original issue discount any increase in the inflation-adjusted principal amount of the instrument that occurs while the investor held the instrument during the year. It also states that the investor should receive Form 1099-OID from the payer showing the amount to report as original issue discount and any qualified stated interest paid during the year. The publication refers readers to IRS Publication 1212 for more detail on inflation-indexed debt instruments.

A hypothetical illustrates the effect. Suppose that, during a year in which an investor holds a TIPS with an original principal of one thousand dollars for the whole year, the index ratio rises from 1.00 to 1.03. The adjusted principal has increased by thirty dollars. Under the rule described above, that thirty dollars is reported as income for the year, in addition to the interest paid, even though the investor has not received it in cash. This illustration is simplified and is not tax advice. FINRA notes that the tax rules that apply to bonds are complicated and recommends consulting a tax advisor.

How Investors Buy and Sell TIPS

The Treasury explains that TIPS are available at auction through TreasuryDirect, or through banks, brokers and dealers. An investor who buys at auction holds the security until maturity or sells it. An investor who buys through a broker-dealer may also buy and sell existing TIPS in the market after they have been issued.

Prices before maturity move with the market. FINRA explains that when interest rates rise, bond prices generally fall, and when interest rates fall, bond prices generally rise. The SEC's investor material adds that if bonds are held to maturity the investor receives the face value plus interest, while a bond sold before maturity may be worth more or less than the face value. These statements describe bonds generally. TIPS address inflation risk, but a holder who sells before maturity may still receive less than the amount paid.

TIPS Compared With Series I Savings Bonds

TIPS are often compared with Series I savings bonds, which are also designed to respond to inflation. The Treasury publishes a comparison, and it shows that the two differ in several ways.

For TIPS, the principal increases or decreases with inflation or deflation and interest calculations are based on the adjusted principal. For Series I savings bonds, the Treasury explains that the earnings come from a combination of a fixed rate and an inflation rate, and that the inflation rate and earnings rate change every six months.

The purchase routes differ. TIPS are available at auction through TreasuryDirect, or through banks, brokers and dealers. Series I savings bonds are purchased online from TreasuryDirect, and the Treasury notes a paper form that is available only using a tax refund.

The tax treatment differs in timing. For TIPS, the interest payments and the inflation adjustments that increase principal are subject to federal tax in the year in which they occur and are exempt from state and local income taxes. For Series I savings bonds, the interest is subject to federal income tax and exempt from state and local income taxes, and the Treasury notes that the interest can be claimed annually.

Risks and Limits of TIPS

TIPS reduce one risk and leave others in place. Several limits are worth keeping in mind.

The first is interest rate risk. The price of a TIPS before maturity can change as market interest rates change, and a TIPS sold before maturity may be worth more or less than its face value.

The second is the match between the index and the investor. The adjustment follows the Consumer Price Index for All Urban Consumers, which measures price changes for urban consumers as a group. An investor's own costs may change by more or less than the index.

The third is the lag. The adjustment is based on index numbers for earlier months, so the adjusted principal reflects past price changes and not those of the current month.

The fourth is the tax timing described above. Because increases in principal are taxed in the year they occur and paid in cash later, the tax bill in a year of rising prices can exceed the cash received in that year.

The fifth is deflation. A fall in the price level reduces the adjusted principal and reduces interest payments during the life of the security, although the payment at maturity is not less than the original face value.

The Term in Exam Preparation

FINRA's content outline for the Securities Industry Essentials examination lists Treasury securities among the debt instruments that a candidate studies. A learner preparing for that examination can review the course overview for the Securities Industry Essentials examination to see how debt instruments fit with the rest of the outline.

Common Misunderstandings

One misunderstanding is that TIPS pay a rate that rises and falls with inflation. The interest rate is fixed when the security is issued. What moves is the principal to which the rate is applied.

A second misunderstanding is that TIPS can never lose value. The repayment at maturity is protected against deflation, because the investor receives the greater of the original face value and the adjusted principal. A TIPS sold before maturity may be worth more or less than its face value.

A third misunderstanding is that the inflation adjustment is tax free until maturity. The Treasury explains that inflation adjustments that increase principal are subject to federal tax in the year that they occur, and IRS Publication 550 directs investors to report the increase as original issue discount.

A fourth misunderstanding is that TIPS follow each investor's personal inflation. They follow the Consumer Price Index for All Urban Consumers, with a lag, and the index measures price changes for urban consumers as a group.

A fifth misunderstanding is that TIPS income is exempt from federal tax. TIPS income is subject to federal tax and exempt from state and local income taxes.

Key Points

TIPS are Treasury notes and bonds whose principal increases with inflation and decreases with deflation, as measured by the Consumer Price Index for All Urban Consumers. They pay a fixed interest rate every six months and are issued with maturities of five, ten and thirty years.

The index ratio is the reference index for a date divided by the reference index for the original issue date. The reference index for the first day of a month is the index for the third preceding month, with linear interpolation for other days. Each interest payment is one-half of the annual rate multiplied by the adjusted principal.

At maturity the investor receives the greater of the original face value and the adjusted principal. During the life of the security, the adjusted principal can fall below the original principal.

Interest and increases in principal are subject to federal tax in the year they occur and are exempt from state and local income taxes, so tax can be due before the cash is received. TIPS can be bought at auction through TreasuryDirect or through banks, brokers and dealers, and their prices before maturity can move with interest rates.