Updated July 17, 2023
Definition of Treasury Inflation Protected Securities
The Treasury inflation protected securities, also known as TIPS, are defined as the treasury securities which get adjusted in price and get maintained in their real value when there is inflation or the price rise in the financial market and the securities which protect the investors from the decline in their purchasing power of the money against the negative impact of rising prices and which are issued by the US government.
Explanation
The Consumer Price Index (CPI) measures the inflation in the US economy. Inflation is the stage at which there is an increase in prices and a decrease in the purchasing power of consumers. Inflation gives rise to very negative impacts, and thus real wage growth also increases. The Treasury inflation-protected securities protect from such inflation to the portfolios. It also creates opportunities to earn profits in the interest they pay every six months, determined at the bond’s auction.
How Does It Work?
The treasury inflation protected the US government issues securities. As the US government issues TIPS, they are considered low-risk investments. The TIPS has different maturity periods, like five years, ten years, and 30 years. TIPS pay the interest every six months, and the interest rate is fixed at the bond auction.
The interest payments on TIPS are calculated based on the changes in the principal amounts. If the principal amounts increase due to inflation, the interest rate will be calculated based on the increased principal amount and vice versa. TIPS can be purchased with a minimum investment of $100 and directly purchased via the direct treasury system.
Example of Treasury Inflation Protected Securities
Let’s take the example of Mr. Peter, who purchases the TIPS and makes an investment of $5000. In this case, the coupon rate is 1%. If there is no inflation and there is a normal situation, Peter will receive $50. If there is an increase in inflation by 5%, the principal amount, i.e., $5000, will get upward adjusted to $5250. Now the coupon rate will not rise even in the case of inflation of 5%. It will remain at 1% only.
However, the principal amount will get adjusted. The coupon amount will be calculated at the revised principal amount, i.e., at $5250 as 1%*$5250= $52.5
The same concept will apply if there is a case of deflation in which the principal amount will get reduced, and the coupon rate will apply to the reduced principal amount.
How to Buy Treasury Inflation Protected Securities?
The Treasury inflation protected securities can be purchased directly from the US Treasury or through banks or brokers in the following ways:
- Directly from the US treasury: In this, one needs to open an account in Treasury Direct and make a bid by accepting the conditions of the auctions.
- By submitting a bid in Treasury Direct: This is the complete online method. In this, we have to log in to the account and click on Buy Direct tab. Then according to our needs, we can select the purchase amount, number, etc.
- Payments and Receipts in Treasury Direct: There are three parts to the TIPS price: the premium, the discount, and the accrued interest. When the TIPS is purchased, the purchase price is withdrawn from the sources of the funds specified, which can be a bank, COI, etc., and at the time of maturity of TIPS, the amount is deposited in the same source from which it is withdrawn.
- Buying through a Bank, Broker, or Dealer: There are two types of bidding offered by the bank, brokers, or dealers: competitive Bids and Non Competitive bids. In Competitive Bids, the yield you want needs to be specified. How small the amount of yield you get is determined by auction.
- In Non-Competitive, whatever yield is determined at the auction, you agree to accept the same. You will get the amount and TIPS you want to be guaranteed.
Treasury Inflation Protected Securities Graph
Below is the graph for treasury inflation-protected securities:
The above chart is for ten years. We can see in the above chart that at the beginning of the year, i.e., in 2016, there was a positive and high yield for the investors. In the middle of the year, the yield falls, and again at the end, i.e., towards maturity, the yield gets hiked. The above graph’s growth depends on the inflation rate in the market.
Advantages
The following are the advantages of inflation-protected securities:
- In TIPS, when there is inflation, the principal amount is adjusted upward per the inflation rate. Hence, at maturity, the investor gets the increased principal amount compared to the original investment.
- The investors consistently earn a profit in the TIPS because he never receives less amount of investment than the original investment at the time of maturity.
- Also, the coupon rate is calculated at the increased adjusted principal amount; hence, the investor gets the increased interest payments due to inflation.
Disadvantages
The following are the disadvantages of inflation-protected securities:
- Generally, in TIPS, the profit depends on the rate of inflation. So, if there is no inflation, there will be no profit. Hence, its utility gets decreases.
- In the increased inflation, there is an increase in principal amount, and hence there are increased interest payments to the investor. This attracts the tax expense for the investor, and he falls in the higher tax bracket.
- The interest rates offered by fixed income bonds that are not dependent on inflation are higher than the interest rates on inflation-protected securities.
Conclusion
In TIPS, the investor will gain profit in case of inflation only if he holds the investments till maturity. However, if the investor sells the security before maturity, the benefit of the inflation and the increased principal amount will not be available for him. This can result in loss also. So, if the investor has the objective of holding the investments till maturity or for the long term, it is advisable to invest in TIPS. Otherwise, the fixed rate bonds are better for investments as they provide a high-interest rate and non-dependence on any market fluctuation or inflation/deflation.
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