» Dictionary of Mutual Fund Terms » Treasury Inflation Protected Securities (TIPS)

Treasury Inflation Protected Securities (TIPS)

Do you hate when inflation merciless eats up the money you have lent to the government? In such a situation, where you want to enjoy the benefits of receiving a monthly income without saying goodbye to your principal, Treasury Inflation Protected Securities (TIPS) may be the financial instrument you are looking for.

Definition: inflation protected types of treasury notes or bonds. The first issuance of TIPS was in 1997, which pacified one of the biggest threats for investors' profits, namely inflation.

Treasury Inflation Protected Securities Functioning

Generally, treasury inflation protected securities can be purchased through a bond fund in order to avoid the unpleasant work surrounding such a procedure. The Consumer Price Index (CPI) is used for the automatic adjustment of the price of treasury inflation protected securities . The CPI influences the value of TIPS in the following ways:

  1. An increase in the CPI corresponds to an identical increase in the value of the treasury inflation protected securities.
  2. A decrease in the CPI does not lead to a decrease in the value of the treasury inflation protected securities, since the government guarantees the initial value of your investment.

Treasury Inflation Protected Security Disadvantages

Let's look at the other side of the coin. Some of the traps hidden in the treasury inflation protected securities are:

  1. High cost.
  2. Lower interest rate than that of similar non-inflation protected securities.
  3. Deflation - the securities become useless in the event of deflation.
  4. CPI problems - possibility of replacing CPI with Chain-Weighted CPI, due to the widely held belief of overstated CPI.
  5. Tradability problems - not as easily tradable as non-inflation protected securities.
  6. Taxes - unless these securities are part of a tax-deferred or non-taxable account, Uncle Sam has the right to levy taxes on the inflation adjustments.

Possible advantage analysis

In order to calculate whether an investment in treasury inflation protected securities is worth the trouble, you should subtract average maturity of a 10 Year Treasury Inflation Protected Security (2.1% for example) from the average maturity of a 10 Year Treasury (3.9 %for example). As a result you will come up with the inflation percentage for the next ten years which will justify investment in TIPS.

Treasury inflation protected securities are extremely suitable in cases when you want to protect your money from the sometimes destructive influence of the inflation. What is more, do not hesitate to buy TIPS whenever you are looking for a safe investment for your tax-deferred account.

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