TIPS

1) Treasury Inflation Protected Securities is a specific type of a US Treasury bond which is designed to protect investors from the effects of rising inflation.

2) The interest rate stays the same but the par value of the bond keeps changing depending on inflation figures of CPI (Consumer Price Index). Similar to regular Treasury bonds, TIPS usually make semi-annual payments.

3) For example:

Consider a TIPS with a par value of $100 and a coupon rate of 2%. For the first year, the investor receives $2 semi-annually. (2% * 100). For the second year, let us assume that CPI increases by 3%. This would increase the par value by the same 3%. So new par value = $103 (3% * 100). Hence, now the investor receives $2.06. (2% * 103) Similarly, the par value would drop if CPI reports deflation.

4) This process will continue until maturity. Upon maturity, the investor will receive the original principal or the adjusted inflation linked principal depending on which ever is higher.

5) A point of concern with TIPS is that the increase in face value of the bond triggers taxes each year, which not only eats into the element of inflation protection but also creates additional tax work. That is why many investors usually by TIPS as part of mutual funds to control operating and taxes expenses.

6) Their advantage is mainly inflation protection, but if inflation is minimal or nonexistent, their utility decreases.