Treasury Inflation-Protected Securities

Treasury Inflation-Protected Securities (TIPS) are marketable securities issued by the U.S. Department of the Treasury whose principal value is adjusted according to changes in a consumer-price index. They pay interest twice a year at a fixed coupon rate applied to the adjusted principal, and at maturity return the inflation-adjusted principal or the original principal, whichever is greater. The design links principal repayment to measured inflation while leaving market value subject to interest-rate and other risks. ^[1][citation needed]

Purpose and background

TIPS are a form of U.S. federal government borrowing. Treasury first offered them in 1997. They are issued in 5-, 10-, and 30-year terms, with interest paid semiannually. Unlike conventional Treasury notes and bonds, whose principal amount remains fixed, TIPS principal is periodically recalculated using the reference index. ^[1][citation needed]

The securities were created to provide investors with a Treasury obligation whose principal responds to inflation as measured by the designated index. The adjustment is contractual: it is not a forecast of inflation, a guarantee that an investor’s overall purchasing power will rise, or a measure of every household’s personal cost of living. Individual expenses may change differently from the index, and the market price of a TIPS can move independently of its inflation adjustment. ^[1][citation needed]

Inflation adjustment and indexation

TIPS principal is adjusted using the non-seasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers, commonly abbreviated CPI-U. Treasury applies an index ratio to the security’s original principal. The ratio is calculated using reference CPI values, with interpolation between monthly index observations to produce daily values. Treasury publishes reference CPI and index-ratio information for outstanding securities. ^[1][2]

When the reference index rises, the adjusted principal rises. If the index falls, adjusted principal can decline. Thus, the amount used to calculate each coupon changes over time even though the coupon rate itself is fixed. For example, a TIPS with a 1% annual coupon rate pays half of that annual rate against its adjusted principal at each semiannual payment date; if adjusted principal has increased, the dollar coupon payment is correspondingly larger. This example describes the calculation, not a current yield or offering. ^[1][citation needed]

At maturity, Treasury pays the inflation-adjusted principal amount or the original principal amount, whichever is greater. This maturity floor applies to principal redemption under the security’s terms; it does not ensure that an investor who sells before maturity receives the original purchase price, nor does it eliminate the effects of taxes, purchase price, or market fluctuations. ^[1]

Coupons and yield

The coupon rate is set at issuance and does not vary during the security’s life. The cash interest payment does vary because it is calculated on the adjusted principal. In a period of inflation, higher adjusted principal ordinarily produces higher dollar coupon payments; in a period of deflation, lower adjusted principal can reduce them. Interest is paid twice yearly. ^[1][citation needed]

Auction results for TIPS report a real yield: a yield stated in relation to the security’s inflation-indexed cash flows, rather than a nominal yield that already incorporates expected inflation. The market’s break-even inflation rate is often estimated by comparing the yield on a conventional Treasury security with the real yield on a TIPS of similar maturity. Such a comparison is a market measure, not a direct or certain forecast: the yields can also reflect differences in liquidity, risk premia, and market demand. ^[3]

A TIPS’ total return over a holding period depends on both changes in adjusted principal and changes in its market price, as well as coupon payments and transaction costs. Real yields can change after issuance. If real yields rise, the market price of an existing TIPS will generally fall, all else equal; if real yields fall, its price will generally rise. Longer-maturity securities usually have greater price sensitivity to yield changes than shorter-maturity securities. The principal indexation feature therefore does not prevent interim losses for an investor selling before maturity. ^[1][3]

Issuance, ownership, and trading

Treasury sells TIPS through auctions. Individuals and institutions can obtain newly issued securities through Treasury’s auction system or through financial institutions and brokers that participate in Treasury securities markets. TIPS may also be bought and sold in the secondary market after issuance. Treasury auction records for TIPS extend back to their first offering in 1997. [citation needed]

As Treasury marketable securities, TIPS are held in book-entry form rather than represented by paper certificates. Investors who purchase through a broker generally hold the securities through the broker’s custody arrangements. An investor selling before maturity receives the then-prevailing market price, which may be higher or lower than the adjusted principal and the purchase cost. TreasuryDirect imposes a 45-day holding period before a marketable security bought in an account there can be sold or transferred. [citation needed][citation needed]

The secondary-market price is influenced by remaining maturity, real interest rates, expected inflation, liquidity, and the specific security’s features. TIPS with different maturity dates and coupon rates can consequently trade at different prices and yields. A fund holding TIPS does not have the same maturity repayment promise for each fund shareholder as direct ownership of an individual security held to maturity; fund shares are priced according to the fund’s portfolio and market conditions. ^[1][citation needed]

Tax treatment

For U.S. federal income-tax purposes, TIPS may generate taxable income from both stated interest payments and increases in inflation-adjusted principal. An increase in principal can be treated as original issue discount (OID) and included in taxable income for the year in which it accrues, even though the associated increase in principal is generally not paid out as cash until a later date or maturity. This timing difference is sometimes described as “phantom income.” IRS Publication 1212 addresses inflation-indexed debt instruments, including reporting and calculation matters. ^[4]

Tax treatment can differ depending on how and when a TIPS was acquired, whether it was purchased at a premium or discount, and whether it is held in a taxable account or a tax-advantaged account. Deflation adjustments and sales or redemptions can also affect tax calculations. Treasury and the IRS provide reporting information, but individual tax outcomes depend on the holder’s circumstances and applicable law. ^[4]

Risks and limitations

TIPS are obligations of the U.S. Treasury, but they are not free of investment risk. Their market prices can fluctuate when real interest rates change. A sale before maturity can result in a loss relative to the amount paid, even if inflation has increased the security’s adjusted principal. Inflation indexation applies to the specified CPI measure; it does not guarantee that real returns will be positive after taxes, expenses, and changes in market value. ^[1][3]

Deflation can reduce adjusted principal and coupon payments during the security’s life, although the original-principal floor applies at maturity. The floor does not generally protect the market price before maturity. Investors who purchase an existing TIPS in the secondary market also pay a price that may differ substantially from its original principal, which affects the return realized if held to maturity. ^[1]

TIPS also carry inflation-measurement basis risk: an individual’s actual inflation experience may differ from CPI-U. Their tax treatment can create liabilities before an investor receives the corresponding principal adjustment in cash. These characteristics distinguish TIPS from ordinary fixed-principal Treasury securities and should be considered when comparing cash flows, maturity dates, tax circumstances, and market prices. ^[1][4]

Relation to other Treasury securities

TIPS are one category of marketable U.S. Treasury debt. Conventional Treasury notes and bonds pay fixed coupon amounts on fixed principal, while TIPS retain a fixed coupon rate but apply it to principal that changes with the index. Treasury bills are short-term discount securities and do not use the TIPS principal-indexation mechanism. ^[1][citation needed]

TIPS are also distinct from inflation-linked securities issued by other governments and from private-sector inflation-linked bonds. Their terms, reference indexes, tax rules, and issuer credit characteristics vary by jurisdiction and product. Within the United States, the CPI-U linkage and maturity principal floor are defining features of the Treasury instrument. ^[1]