What are Treasury Inflation-Protected Securities
Treasury Inflation-Protected Securities (TIPS) is a type of U.S. Treasury (government bond) that the principal of the Treasury Inflation-Protected Securities will be increased with inflation and decreased with deflation to maintain the principal value. While the inflation rate is measured by the Consumer Price Index (CPI).
TIPS pays interest twice a year at a fixed rate (called a coupon payment). When a Treasury Inflation-Protected Securities (TIPS) matures, the investors are paid the inflation-adjusted principal or original principal, whichever is greater.
- When inflation rises, the principal increase.
- When inflation falls, the principal decrease.
Normally, the investor uses Treasury Inflation-Protected Securities to diversify their portfolio to protect the portfolio against inflation when the economy is not performing well. This is because inflation adjustment helps the investors will never receive the lower amount of the invested principal.
What are Treasury and Bond
A government bond is a bond issued by the government. A bond is an agreement issued by the borrower (the government in this case) to borrow money from investors. Treasury bonds or Treasury is a government bond issued by the U.S. Federal government.
An investor who buys a bond gives the bond issuer a loan, and they agree to repay its debt in the amount of the face value at the due date. In return, the issuer promises to pay a specified rate of interest to an investor annually, semi-annually, or at another interval.
However, no matter type of bond, bonds are shared the following common terms:
- Face value is a price of a bond. This is the amount of money that the bond issuer borrows money from the investor and must repay at maturity. This is also known as the principal invested.
- Maturity date is the date on which the issuer must pay back the bondholder by its face value.
- Coupon rate is the interest rate paid by the bond to the investor. This is a fixed rate and remains the same throughout its lifetime. If a bond has face value of $10,000 and coupon payment is 1,000 per year, then coupon rate is 10% ($1,000 / $10,000 = 10%).
- Coupon date is the date that the bond issuer will pay interest to the bondholder. Normally, it is paid annually, or semi-annually.
- Issue price is the price of a bond that the bond issuer sells the new bonds.
As we mentioned above, Treasury Inflation-Protected Securities (TIPS) are adjusted by inflation. Thus, the investors are paid the inflation-adjusted principal or original principal, whichever is greater. When inflation rises, the principal increase. Conversely, when inflation falls, the principal decrease.
Drawbacks
The higher risk, the higher return. Treasury Inflation-Protected Securities (TIPS) is an investment that is considered a risk-free investment that guarantees the same value of the principal invested at the mature, in exchange Treasury Inflation-Protected Securities (TIPS) give you lower interest rates compared with other bonds.
Other than that, the Consumer Price Index (CPI) does not really reflect the actual inflation that happened in the real life. So, Treasury Inflation-Protected Securities sometime do not maintain your purchasing power as you expect.
