Treasury Inflation Protected Securities
What is an Inflation Protected Security?
TIPS, or Treasury Inflation Protected Securities were introduced into the bond market in early 1997. TIPS are issued by the United States government and therefore have no default risk associated to them. As with Treasury bonds, TIPS are issued through the Federal Reserve auction quarterly and can be purchased through the Treasury Direct system and coupon payments are made on a semi-annual basis.
The unique feature with these bonds is that their principal is tied to the CPI (Consumer Price Index). The CPI measures the rate of inflation monthly by measuring price changes in common consumer goods. Treasury inflation protected securities guard the value of your investment by increasing the principal value of your bond by the rate of inflation, ensuring that periods of high inflation will not erode the relative value of your coupon. The term "relative" is used here because the interest rate of a bond will mean much less if inflation is very high and visa versa.
You can perform a very simple analysis to determine if the treasury vs. treasury TIPS yield spread (aka. "TIPS Spread") makes it worthwhile to invest in the TIPS. For example, assume the yield on a 5 year TIPS is 3.5% while the yield on a treasury bond with the same maturity is 6.25%. Now assume an average inflation rate of 3%. The TIPS would actually yield 6.5%, or 25 basis points higher than the treasury bond of the same term to maturity. Through investing in TIPS, you are basically making a bet that inflation will move higher over the period of your bond term.
Potential Risks of Investing In Treasury Inflation Protected Securities
The first risk factor of investing in TIPS is that the measurement of inflation is done through CPI. The CPI measurement may not be completely accurate so the principal balance of the TIPS may not increase alongside with true inflation.
Secondly, if interest rates spike higher, TIPS yields may rise as well. This would negatively impact the price of the bond on the short run; however, TIPS should still outperform on the long run.
Another downside of investing in treasury inflation protected securities revolves around the fact that they do not pay the inflation adjustment out until the bond matures. This has in implied risk, albeit almost zero since the United States government is backing this security. Also keep in mind, the inflation adjustment that the bond receives will be taxable yearly, even though you do not receive this cash. Basically, you will be charged on income not yet realized.
Finally, and least importantly, there is a deflationary risk. While deflation has not been around for quite a few decades, it is a possibility and TIPS will adjust your principal lower to account for deflation. There is a safety net, if you will, that does not allow the principal balance to drop below the original amount.
In conclusion, TIPS can be a good investment for those of you who believe that inflation is here and here to stay. When general market yields move higher, TIPS begin to underperform similar maturity fixed income investments due to a potential drop in inflationary pressures, which will in turn drop the price of the bond in the short run. Longer term, treasury inflation protected securities provide as a good hedge against inflationary and even hyperinflationary environments.