Source: sxc.hu Photo: kikashi

Source: sxc.hu Photo: kikashi

Ever since the Federal Reserve lowered their key interest rate to 0%-.25%, there has been talk of rampant inflation becoming an issue.  Many economists even consider the possibility of hyper-inflation, a period of rapidly rising prices along with a declining value in the dollar.  All signs seem to point to at least a period of higher inflation, but that doesn’t mean you can’t take advantage of it with your investments.  This post will focus solely on Treasury Inflation Protected Securities, known as TIPS.

What are TIPS

TIPS were first introduced in 1997 by the Federal Government and have become widely popular among long-term investors looking to preserve their purchasing power.  Like all Treasury bonds and notes, they are essentially loans to the U.S. Government.  You receive interest every six months at a specified rate.  TIPS are designed the same way except that your interest payments will be based on inflation.

TIPS guarantee that your interest payments will go up based on inflation, whereas a regular bond will guarantee you how much you will receive in interest over a set time period.  Essentially you are trading the stability of knowing exactly how much money you will receive from your bond with the comfort of knowing that when inflation goes up your purchasing power remains in tact.

How Do TIPS Work

TIPS pay a slightly lower interest rate than comparable Treasury securities because twice a year your principal is adjusted to match the Consumer Price Index (CPI), a widely used measure of inflation.  For example, let’s say you have $10,000 in a TIPS bond and the fixed interest rate is 3%.  Over the next six months, if the annual inflation rate goes up by 4% your principal will go up by 2% (half of the inflation rate of 4%) to $10,200.

Remember, your interest rate stays the same, it is your semi-annual payment that differs.  So your new principal amount earns the fixed rate of 3%, which would pay you $306 ($10,200 x 3%)  instead of $300.  If inflation goes up again, your principal will be even higher and so on.  If inflation eases, your principal will be adjusted lower and will reduce your interest payment.

Tax Treatment of TIPS

Tax treatment for TIPS are a little different than other bonds.  The US Treasury records changes to your principal every six months, however, you don’t actually receive that money until the bond matures.  But guess what?  Uncle Sam still wants to collect his taxes on the increases you haven’t received.  Be aware that you’ll have to include these increases in your ordinary income.  This is why many people prefer to hold these bonds inside a tax-deferred account like an IRA.

Buying TIPS

TIPS can be purchased at 5, 10 or 20-year maturities in increments of $100.  It may be a wise move to “ladder” your purchases, which simply means you buy TIPS with varying maturity levels so that as your bonds come due you have a choice of either reinvesting if interest rates are higher or finding an alternative investment if rates on TIPS are lower.

You can also buy TIPS in a mutual fund or an Exchange Traded Fund (ETF).  A mutual fund will pay out your interest earned plus any annual inflation adjustments, which are then taxed at short-term capital gains rates.  Before investing into a fund you should carefully weigh your options and consider the funds’ expenses, risk and investment objectives.

With inflation poised to be an issue in the near future, TIPS can be a great supplement to any portfolio to help increase your dividends and returns.