Want some hot investment TIPS? Check out U.S. Treasury Inflation-Protected Securities!
While these types of securities have been available in Canada and the United Kingdom for many years, the U.S. Treasury issued the first inflation-indexed securities (TIPS) in early 1997.
Although they are similar in some ways to bonds, TIPS provide actual protection against inflation. Why? Because your interest, income and principal payments are adjusted for inflation.
How do TIPS work?
Like bonds, TIPS are IOUs of money ("principal") at a fixed percentage of interest for a specific amount of time. However, while a bond's principal (or par) values and interest payment rates are always fixed, a TIPS' principal changes with the Consumer Price Index (CPI), a measure of inflation. Because interest is calculated as a percentage of the principal, the amount of interest payments also changes with inflation. The day-to-day value of TIPS varies with changes in inflation and interest rates.
Now, let's compare a bond to a TIPS:
As you will see, the principal value at the time of the semi-annual payment is higher for the TIPS because it's been adjusted by the CPI increase. Let's assume that both the bond and the TIPS have a fixed interest rate of 3% and that inflation is increasing at an annual rate of 3%.
|a. Principal ("par") value when first issued||$1,000||$1,000|
|b. Interest rate every 6 months||1.5%||1.5%|
|c. Inflation (CPI)* increase to 6-month interest payment||N/A||1.5%|
|d. Principal at time of first 6-month interest payment (a times c)||$1,000||$1,015|
|e. First interest payment after 6 months (b times d)||$15.00||$15.23|
|f. Principal at time of second 6-month interest payment (d times c)||$1,000||$1,030.23|
|g. Interest rate every 6 months||1.5%||1.5%|
|h. Second payment after another 6 months (f times g)||$15.00||$15.45|
|i. Total interest payments in first year (e plus h)||$30.00||$30.68|
What's the tip on TIPS? They can give you a relatively safe investment from the U.S. Treasury with the inflation protection you need to shield your retirement nest egg from increases in the cost of living.
* There is a three-month lag from the time the CPI is calculated to when it's applied to TIPS, which has a slight effect on the inflation protection offered by TIPS. Also, if there's deflation (prices go down) when the TIPS is due, the U.S. Treasury will redeem it at par, not at a discounted price - which works to your benefit.