Earlier this week I inadvertently introduced the concept of the inflation protected securities when I wrote about bogleheads’ investment strategies. Treasury Inflation Protected Securities (TIPS) can be purchased at www.treasurydirect.gov, in $100 increments (minimum $100 purchase) and are available in 5, 10 and 30-year maturities; however, they are more commonly purchased by individual investors as a part of a mutual fund (e.g. VIPSX). But what are inflation protected securities?
Essentially, they are a security, issued by the treasury department, where by the investor’s initial principal is protected against inflation. So let say an investor purchases a 5-year $100 inflation protected security with a yield of 1% from the treasury department at a time when inflation is running 3% per year. A normal security would give the investor 1% return per year ($1) and then at the end of 5 years return the purchaser’s $100. At the end of the 5 years, the value of the $100 would be reduced to about $86 because of inflation – so the investor would have lost money. With TIPS, the investor’s $100 would be adjusted by 3% per year for inflation so in the first year, the investors principal would be adjust to $103 dollars and the bond would pay out $1.03. This would happen each year and at the end of 5 years the investor would get around $116 returned. What happens if there is deflation? The principal would be adjusted downward and annual interest payment would reflect this; nevertheless, at maturity, the investor would get back the original $100. At maturity, these bonds return either the original principal or the principal adjusted for inflation - which ever is greater.
This sounds like a win-win for the investor – but there are issues. The most problematic is that when the bond value is adjusted for inflation, the IRS considers these adjustments as income even though the investor will not receive the monies until sometime in the future – or never if they sell the bond before maturity. For this reason, many investors only purchase these securities for tax-privileged accounts (IRA, 401K, etc.). The other issue is that because they are protected from inflation, these bonds often pay a lower rate of interest.