Treasury Inflation-Protected Security Definition

Since the treasury inflation-protected securities are issued by the US Treasury and provide a hedge against the inflation riskInflation RiskInflation Risk is a situation where the purchasing power drops drastically. It could also be explained as a situation where the prices of goods and services increase more than expected. Inflation Risk is also known as Purchasing Power Risk.read more, they are considered a very low-risk investment. They are issued in three maturities of five, ten, and thirty years.

How Treasury Inflation-Protected Security Works?

The principle of TIPS security is linked to an inflation index. As inflation in the economy rises, the bond’s principal or face value goes up. The coupon of a bondCoupon Of A BondCoupon bonds pay fixed interest at a predetermined frequency from the bond’s issue date to the bond’s maturity or transfer date. The holder of a coupon bond receives a periodic payment of the stipulated fixed interest rate.read more is calculated as the interest rate (or coupon rateCoupon RateThe coupon rate is the ROI (rate of interest) paid on the bond’s face value by the bond’s issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100%read more) multiplied by the bond’s principal.

In an inflationary environment, the coupon of a bond which is paid periodically (quarterly, semi-annually, or annually), also increases in the corresponding period (due to increased principal), which results in higher coupon payment to the investor and thus protecting them from the inflation risk. Conversely, if deflation (prices of goods and services) goes down, then the principal of TIPS goes down, and investors will receive lower coupons.

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Treasury Inflation-Protected Security Examples

Given below are the examples of Treasury Inflation-Protected Securities (TIPS).

Example #1

Fixed-rate bonds carry the risk that inflation erodes the values of the coupon payment as the coupon interest, and thus the coupon amount of the bond is fixed for the bond’s life.

For example, if a bond pays a coupon of 3% annually over the life of the bond and the current inflation rate in the economy is 4%. The investor is at a loss in real terms as inflation has completely eroded the value of the coupon payment. TIPS protect investors in such scenarios.

Example #2

Suppose an investor owns USD 100 in Treasury Inflation-Protected Securities with a coupon rate of 2% annually. If there is no inflation in the economy, the investor will receive a coupon payment of USD 2 annually. However, suppose there is an inflation of 4% in the economy. In that case, the bond’s original USD 100 face value will be adjusted to USD 104, and the coupon payments of the security will now be calculated on USD 104 principal.

So the new coupon payments of the security will be USD 104 * 2% = USD 2.08. If the inflation rate persists at 4% at maturity, the investor will receive the inflation-adjusted principal of USD 104. Thus, with increased coupon and principal payment at maturity with an increase in inflation, TIPS protects the investor from inflation risk.

Example #3

Suppose there is a deflation in the economy, i.e., prices of goods and services are going down. The deflation in the economy is 2%. The principal of the Treasury Inflation-Protected Securities will be adjusted downwards to USD 98, and the coupon payments will be calculated on the USD 98 face value.

In this case, coupon payments will decrease in value with deflationDeflationDeflation is defined as an economic condition whereby the prices of goods and services go down constantly with the inflation rate turning negative. The situation generally emerges from the contraction of the money supply in the economy.read more. However, at the bond’s maturity, the investor will be nothing less than the original face value of the bond, which is USD 100. So, one big advantage of TIPS is that in case of deflation, the principal value of the security is not adjusted at maturity, and the investor receives a higher amount invested or the adjusted higher principal.

Advantages of TIPS

  • It provides a hedge against the inflation risk. The principal of a treasury inflation-protected security is adjusted with the inflation trend in the economy; thus, the principal and coupons are inflation-adjusted.Coupon payments of TIPS increase in an inflationary environment as it is calculated on the inflation-adjusted principal.When the TIPS mature, investors are never paid less than the bond’s original face value (principal).

Disadvantages of TIPS

  • Since they provide a hedge against the inflation risk, the coupon rate of TIPS security is generally lower than that of a comparable fixed-income instrument without an inflation adjustment.TIPS generally are subject to higher taxes as coupon payments are higher with increased inflation.In the case of inflation in a flattish economy, investing in TIPS is of little use as the face value of the bond will remain more or less constant due to the non-inflationary trend.

Conclusion

TIPS protect investors from the inflation risk inherentRisk InherentInherent Risk is the probability of a defect in the financial statement due to error, omission or misstatement identified during a financial audit. Such a risk arises because of certain factors which are beyond the internal control of the organization.read more in the economy. If the inflation in the economy is higher than the bond coupon rate, then the value of the periodic coupon is eroded in real terms because of the higher prices. In such cases, TIPS protect the investors as they adjust the principal of the bond to the inflation; thus, both principal and coupon are linked to inflation and protected. Higher the inflation, the higher the principal and coupon payments.

However, TIPS generally carry lower coupon rates as they protect the investors from inflation risk. Also, investing in TIPS in a non-inflationary environment will lead to lower returns. Thus, investment in TIPS should be made after analyzing the current inflation trend in the economy and looking at the future predicted trend.

This has been a guide to Treasury Inflation-Protected Securities (TIPS). Here we discuss how treasury inflation-protected security works along with examples. You can learn more about fixed income from the following articles –

  • Bonds MeaningTypes of Bond RisksZero-Coupon Bond FormulaCorporate Bonds Definition