Treasury Inflation-Protected Securities
Treasury Securities are debt instruments that are issued by a government to finance government spending as an alternative to taxation. Funds collected through such tools are typically used to meet the short term requirements of a government, hence, to reduce the overall fiscal deficit of a country. These securities are usually seen as very safe investments since it’s not everyday news that governments fail to meet their obligations and as such, the interest rates on such securities are usually lower than what you’d get by parking money into another type of instrument.
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Treasury yields are also usually benchmarked for all other interest rates. But what if expect the inflation rates to rise? In such a case, coupled with the already low-interest rates of treasury bills, you’d end up losing a significant amount of money on your investment. Fortunately, Treasury Inflation-Protected Securities (TIPS) are a good alternative.
How Treasury Inflation-Protected Securities work?
Compared to regular Treasury Bills, TIPS is a variation of regular Treasury Bills that protects investors from rising inflation by adjusting their interest rates on the basis of rising inflation rates. The adjustment made is also on a semi-annual basis. The way this works is, if the inflation rises, then the principal value (or face value) of the TIPS rises. As the principal value changes, the coupon payment, which is based on the face value of the bond will also change. The end result of the inflation increase is that you end up with a higher coupon and principal payment. TIPS are usually issued with a maturity of 5, 10, and 30 years, similar to regular Treasury Bonds. They can be purchased directly from the government through its Treasury Direct system in $100 increments with $100 being the minimum investment. Alternatively, you could also purchase TIPs from a mutual fund or exchange-traded fund (ETF). Purchasing TIPS directly lets investors avoid the management fees that are associated with mutual funds.
Pros and Cons of Investing in TIPS:
Pros:
- Provides a good investment opportunity that is linked to the inflation rate.
- A good investment if in case the inflation rates are projected to increase.
- Most of the nations issue TIPs including the U.S., Canada, India, etc.
- Available in a minimum investment of $100 with $100 increments in 5, 10- and 30-years maturity periods.
- Considered very safe investments as governments don’t usually fail.
Cons:
- The increase in face value due to adjustment is seen as taxable income in the U.S.
- With the rising inflation seen as a positive thing for TIPs, Deflation runs a risk for an investor with inflation-linked security. It decreases the principal amount as well as the coupon payments associated with it.
- May lead to taxation on Phantom income since the investors don’t get the adjustments in the running year itself but rather at the end of maturity of the bond. The separation is done because of tax purposes since the adjustments are taxable.
Example:
Imagine a bond with a face value of $1,000, a 3% coupon rate with semiannual payments with a maturity of 3 years. In the first year, you’d receive $30 as coupon payments. Suppose in that year the CPI (consumer price index measuring inflation) rises by 4%. As a result of this, the face value of the bond rises by 4% as well to $1,040, and coupon payments after the adjustment would be 3% of the new face value, $31.20. Suppose in that year the CPI drops by 2%. The face value of the bond, in that case, would increase to 1060.80, and the investor would receive an interest of $31.82. Hence, with an increase in inflation, the investor with an inflation-linked bond enjoys an upside.
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Final thoughts:
TIPs may seem a little complicated due to their inflation-linked nature, potential downside due to deflation, and complex taxation, but they still remain a very popular investment. Their use for hedging positions against short term inflation is widespread. They also work wonderfully for diversification purposes since they do not correlate with stocks or other fixed-income assets.
Author: Aman Aggarwal
About the Author: Aman is an Economics and Finance graduate with a budding interest in Strategic Management and Investment. An avid reader of all things Behavioral and Data Science –I strongly believe in solving problems with creative solutions backed up by quantitative rigor.
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