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Preserve Your Principal with Treasury Inflation Protected Securities (TIPS)

written by: Kantha Wijeratne•edited by: Laurie Patsalides•updated: 4/11/2011

US Treasury Inflation Protected Securities (TIPS) issued by the US federal government have a unique feature. They lead to investment gains during times of inflation. Learn more about TIPS and how they can help to minimize the negative effects of inflation in your portfolio,

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    Introduction

    Investors face many risks when they invest in stocks, bonds and other securities. Price fluctuations due to market volatility, interest rates and inflation affect the value of their portfolios and return on investment. The risks arising from inflation can be minimized by holding a part of the fixed income securities in a portfolio in the form of US Treasury Inflation Protected Securities (TIPS).

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    What are US Treasury Inflation Protected Securities (TIPS)?

    US Treasury Inflation Protected Securities can be defined as investments that are protected against inflation. First issued by the US federal government in 1997, TIPS are marketable securities that have terms to maturity of 5, 10 and 30 years. They are issued in electronic form. Starting with a minimum investment of $100, they can be increased in multiples of $100.

    Treasury inflation protected securities can be purchased through non-competitive bids from TreasuryDirect, Legacy Treasury Direct or from banks, brokers, dealers or through a mutual fund. Legacy Treasury Direct does not offer 30 year TIPS. The price and interest rate for the securities are determined at the auction. TIPS up to a value of $5 million can be purchased through non-competitive bidding. Competitive bids channeled through a bank, broker or dealer can be allotted up to 35% of the securities on offer.

    An investor in TIPS can be an individual or an entity such as a trust, estate, corporation, partnership or a sole proprietorship. In the case of an entity, a person specified as an entity account manager holds the authority to represent the company or trust.

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    How Does TIPS Work?

    An investor in TIPS receives a semiannual interest payment based on a fixed rate. Interest is calculated on the principal balance that is adjusted for inflation based on the Consumer Price Index. For example, if the interest rate on the security is set at 2% and inflation is at 7%, then the principal balance is increased by 7% to compute the semiannual interest payment. Both the interest payment and principal balance of TIPS increase with inflation.

    The reverse happens when there is deflation. The principal balance is adjusted downwards leading to a lower interest payment. If the securities are held to maturity, the investor receives the inflation adjusted principal balance or the original principal, whichever is higher. Treasury inflation protected securities ensures that your principal is preserved even under deflationary conditions.

    New or recently issued TIPS that are bought and held to maturity pose the least risk to an investor. Older TIPS purchased in the secondary market may have a price that reflects any accrued inflation adjustment to the principal value of the security. An investor faces the risk of the securities falling in value and so eroding the investment, if there is deflation following the purchase of TIPS.

    Earnings from treasury inflation protected securities are exempt from subject to federal tax. The interest payments and any gain in principal value due to inflation for the current year are subject to tax even though the appreciation in capital has not been realized in cash terms. As such, it is best to hold TIPS in a tax advantaged account such as an IRA or Roth IRA.

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    Advantages of Investing in TIPS

    TIPS can form an important component of asset allocation in a portfolio. Typically, fixed income securities provide a lower return than equities but are held within a portfolio to lower the volatility in the asset mix. When there is inflation, monetary bonds pay out less interest while TIPS pay more. The reverse happens with deflation; holding a mix of TIPS and monetary bonds can help to reduce the volatility of a portfolio while increasing overall returns. For retirement planning purposes, TIPS can also be held to advantage in an index fund. Similar to stocks and bonds, they can also be held tactically to profit from an anticipated rise or decline in inflation.

    Treasury Inflation Protected Securities issued by the US government have a guaranteed real rate of return. This feature is absent from normal Treasury bills and other types of securities available in the market. Similar to other securities, purchasing them at a low price can ensure higher returns. Even with deflation, there is a guarantee that the principal value would be preserved at maturity. Purchasing TIPS can be one of the better ways of investing, particularly for retirement planning in an inflationary setting.

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    Resources

    TreasuryDirect, http://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm