Do you remember Wimpy? He was the Popeye's cartoon character who understood that inflation erodes purchasing power. Wimpy made the famous and oft quoted offer, "I will gladly pay you Tuesday for a hamburger today." He obviously understood inflation (or maybe he simply didn't want to pay for his burger). His dollar was worth more today than tomorrow.
Wimpy battled inflation with his charm while in the real world, investors buy stocks. Another investment to fight inflation is Treasury Inflation-Protected Securities (TIPS). TIPS can be purchased from the US Treasury or on the secondary market (through brokerage firms and banks). You can also buy mutual funds that own TIPS.
What Are Treasury Inflation-Protected Securities?
The US Treasury began issuing Treasury Inflation-Protected Securities in 1997. TIPS are quite different than a typical US Treasury Bond.
Characteristics of TIPS are:
- Available with maturities of 5, 10 and 20 years
- Principal of the bond increases/decreases with the rate of the Consumer Price Index (CPI)
- Interest payments are a fixed percentage applied to an increasing/decreasing principal
- Principal adjustments and interest payments are made twice a year
- The adjusted principal or the original principal, whichever is greater, is paid to the investor upon maturity (if bought at par value at the initial offering/auction)
Example of a Treasury Inflation-Protected Security
Treasury Inflation-Protected Securities are very different from conventional bonds. A conventional fixed rate coupon bond makes coupon payments on the par amount (example: 5% annual interest payment on $1,000) and the par amount is returned at maturity of the bond. Not so with TIPS.
I have outlined an example of a TIPS investment from beginning to end. For the sake of simplicity, the example demonstrates a bond that is purchased at the US Treasury auction, at par value and with a steadily increasing Consumer Price Index.
- An investor goes to www.treasurydirect.gov and buys a five-year $10,000 Treasury Inflation-Protected Security at auction with a 1.00% coupon.
- The Consumer Price Index for the first period is 3% (a semi-annual rate of 1.5%)
- As a result of the CPI, the value of the bond is increased by 1.5% to $10,150.
- A coupon payment of $50.75 (50% of the 1.00% fixed coupon multiplied by the adjusted principal of $10,150) is made to the investor.
- At the end of calendar year one, the investor is taxed on the coupon payments and the adjustments to principal. This taxation is continued throughout the life of the bond.
- The investor continues to receive the coupon rate multiplied by the adjusted principal on a semi-annual basis (in this case the adjusted principal is increased by 1.5% every six months).
- At maturity, five years from the date of the auction, the investor receives the adjusted principal of $11,605.41 and the final coupon payment of $174.08 (1.5% on the $11,605.41).
Taxation of Treasury Inflation-Protected Securities
The example mentions that the investor is taxed on both the annual income and the amount of the adjusted principal (i.e., the increase in the principal amount due to CPI). The tax on the adjustment is referred to as "phantom income." Many investors wisely choose to hold TIPS in a tax-deferred retirement account (e.g., IRA) to avoid the taxation. TIPS investors will receive a Form 1099-OID for the phantom income and a Form 1099-INT for the interest payments (if the TIPS are held in a taxable account).
Treasury Inflation-Protected Securities Mutual Funds
For more an in-depth look at TIPS, see the interview with John Hollyer, co-manager of the Vanguard Inflation-Proteced Securities Fund.