A TIPS Refresher

by : David M. Haviland | POSTED: Jun09, 2017 | CATEGORY: Economics, Financial Literacy f

For those that need a refresher, here is a recent article from Financial Advisor magazine that helps describe Treasury Inflation Protected Securities (TIPS).  

A TIPS Refresher

With inflation out of the picture for so long, many investors have ignored TIPS and TIPS ETFs, or forgotten how they work. Here’s a brief refresher.

 

RATES AND TERMS

TIPS are issues in terms of five, 10 and 30 years and can be purchased as new issues or on the secondary market. Although their coupon is fixed, the principal rises when the Consumer Price Index (CPI-U) adjusts upward and falls when it moves in the opposite direction. This means the semiannual interest payments will vary throughout the life of the bond, with investors receiving larger interest payments when prices rise, and smaller payments when they fall. When the security matures, the U.S. Treasury pays the original or adjusted principal, whichever is greater, so investors never get less than the principal value at maturity as long as they hang on to a bond. Because TIPS ETFs trade constantly, they have no set maturity date.

 

TAXES

Interest income and growth in principal are exempt from state and local income taxes, but subject to federal income tax.  Investors receive Form 1099-INT for the interest payments and Form 1099-OID for the changes to principal. Increases in principal are taxable in the year they occur, even if the bond hasn’t matured. The fact that TIPS ETF returns from both principal and interest are taxable in the year they are realized makes them better suited for tax-deferred accounts.

 

TIPS VERSUS TREASURYS

Because they offer the potential for increases in principal because of inflation, TIPS have much lower yields than traditional Treasury securities of the same maturity. The difference between the two, or “breakeven,” measures how high inflation must be over the life of the bond for the TIPS to be the better alternative. For example, if a 10-year TIPS bond yields 0.8% and a 10-year Treasury yields 2.8% the breakeven would be 2%.

 

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Source: Financial Advisor Magazine, page 47. Time For TIPS ETFs? They have attractive attributes, but investors often overlook risks. Marla Brill. March 2017

 

    

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