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A Treasury inflation-protected security (TIP) is a special type of note or bond that the U.S. Department of the Treasury uses to finance the public debt. At the same time, the Treasury inflation-protected security offers investors protection from the up and down swings that come with inflation. These securities are also called Treasury inflation-indexed securities.
These securities typically are purchased in multiples of $100 US Dollars (USD) through Treasury Department public auctions. Bids may also be placed through a government-approved bank, broker or dealer. Auction dates for treasury bonds and treasury notes are announced in major newspapers and online press releases at the department’s Web site. Investors may also subscribe to e-mail notifications.
Inflation is a rise in the cost of goods and services. As inflation increases, the base amount an investor puts in a Treasury inflation-protected security, known as the principal, simultaneously increases at the same rate as the Consumer Price Index (CPI). On the other hand, during deflationary periods, when prices are dropping, the principal likewise decreases.
The CPI is a weighted average of prices of a basket of consumer goods and services. It is used to measure increases and decreases in the cost of living for consumers. Although the CPI experiences some volatility over time, a Treasury inflation-protected security is considered to be a safe investment because the principal is not compromised when the CPI cycles down. If deflationary pressures cause the interest-adjusted principal to dip below the original investment amount, the original principal is paid out in full at maturity.
But there is a trade off for that piece of mind. Treasury inflation-protected securities (TIPS) offer a lower return. The U.S. Department of the Treasury provides an online TIPS Inflation Index Ratios page to help investors calculate changes to principal, according to changes in the CPI.
Treasury inflation-protected securities pay interest every six months at a fixed rate and pay the principal to the investor upon maturity. They mature in terms of 5 years, 10 years and 20 years. For example, a 10-year TIPS note can have a semi-annual interest rate of 4 percent or 3.875 percent, with yields of 4.075 percent or 3.937 percent.
Interest on a Treasury inflation-protected security is exempt from state and local income taxes but it is subject to federal income tax. Federal income tax on interest payments is applied to the year the interest is received. With respect to growth in principal, federal income tax applies in the year that it occurs.
A Treasury inflation-protected security can be held to maturity or sold before the maturity date. Upon maturity, the principal can be used to buy another security. Investors do not have to take any special steps to redeem TIPS. The Treasury Department will automatically deposit the principal into a previously designated bank account.