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TIPS as a Fixed Income Strategy PDF Print E-mail
Written by Kevin Grogan   
Thursday, 07 May 2009 00:00
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Overview:
Many investors may be sensitive to the damaging effects inflation can have on the buying power of their portfolios. One way to address this concern is through Treasury inflation-protected securities (TIPS). 

There is an old saying in the investment world that the only returns that matter are the ones investors can spend. Thus, investors should account for the effects inflation can have on their spending power. Inflation poses significant risks to investors over the long term as it may decrease their buying power. One way to account for the effects of inflation is through fixed income investments in Treasury inflation-protected securities (TIPS).
 
What Are TIPS?
Similar to nominal (non-inflation-adjusted) U.S. Treasury fixed income investments, TIPS are issued with fixed coupon rates and fixed maturity dates (such as five, 10 or 20 years). The key difference between TIPS and nominal bonds is that the coupon rate for TIPS is a guaranteed “real” (inflation-adjusted) return. The principal is adjusted for inflation before the interest payment is calculated.
 
With TIPS, the coupon payments and face value will maintain purchasing power until maturity. Rates for nominal Treasury fixed income investments are typically higher than the rate for TIPS with comparable maturities because they include a risk premium for future inflation. However, there is no guarantee the coupon payments will retain purchasing power.
 
How Do TIPS Work?
The principal value of TIPS is adjusted by the Treasury Department according to changes in the Consumer Price Index for All Urban Consumers (CPI-U). The semiannual interest payments vary because the fixed coupon rate is applied to the inflation-adjusted principal, as illustrated below:
 
Year
Inflation
Rate (%)
Amount of Principal
Adjustment $)
Adjusted
Principal
Value ($)
Total Coupon
Payment ($)
1
0
0.00
100,000.00
3,000.00
2
2
2,000.00
102,000.00
3,060.00
3
1
1,020.00
103,020.00
3,090.60
4
3
3,090.60
106,110.60
3,183.32
5
1
1,061.11
107,171.71
3,215.15
Note: Example assumes an individual TIPS with a $100,000 principal value and a 3 percent coupon rate.


Last Updated on Friday, 14 August 2009 06:57