TREASURY CLASSROOM VOLUME 122

TREASURY INFLATION-PROTECTED SECURITIES

Now it's a type of security that is issued by the US government and is indexed to inflation. As it is linked to inflation investors are protected from the decline in the purchasing power of the money.

In this, the principal value is protected since the investors will never receive less than they originally invested principle. Now interest rate paid on the bonds is fixed so in this case if the inflation prices then there is a loss in real terms to the investors

Let's understand with the simple example

Suppose there is an investor who owns around $1000 of TIPS with a coupon of around 1% now at the end of the year the investor receives $10 in a coupon. Now if inflation rises by around 2%, then the $1000 principal will be adjusted by 2% to $1020 and the coupon rate will be the same as 1% but the principal will be adjusted as now the coupon will be around $10.20.

Now on the reverse side of the inflation were to be negative with prices going down by 5% then in that case the principal would be adjusted down to $950 and the coupon will be around $9.50. Now when the TIPS mature the investors receive the inflation-adjusted principal or the original principal whichever is greater. And also this benefit investor will be getting if he is holding tips till maturity. If the investors sell the TIPS in the secondary market then in that case in event of deflation the investors will be receiving the less money

Usually, the TIPS generally pay lower interest rates than other government securities as their advantage is mainly inflation protection.