TIPS—short for Treasury Inflation-Protected Securities—offer investors the closest thing Uncle Sam has to a sure bet these days. These bonds have the full backing of the U.S. government and provide investors with returns that will keep pace with future rates of inflation, as measured by the U.S. Consumer Price Index. You can buy them directly from the government, but it's easier—and a better investment decision in many cases—to buy low-fee investment funds that hold TIPS.
Many advisers are recommending TIPS, both for their safety and because of widespread concern about the inflationary implications of record government deficits. Investors burned in last year's market declines have become more cautious about their holdings and are particularly wary of risky investments as they near or reach retirement age.
The U.S. Treasury says the public held $512.8 billion in outstanding TIPS at the end of March, up about $40 billion over the previous 12 months. About 8 percent to 10 percent of this total is held by individuals in investment funds. There is no accurate measure of direct consumer purchase of TIPS at auctions but the closest measure—noncompetitive bids at TIPS' auctions—would total only $15 to $20 billion.
How they work. TIPS are sold at auction several times a year in maturities of 5, 10 or 20 years. They pay a fixed rate of interest, but that rate is applied to a fluctuating principal amount of a TIPS bond which rises with inflation or falls with deflation. Interest payments are made every six months. Although TIPS are generally touted as protection against inflation, they also offer some protection against deflation. That's because TIPS guarantee to pay at least their original principal at maturity. Put another way, if prices double during the life of a TIPS bond, a $1,000 TIPS would automatically rise to a principal value of $2,000. If prices fall by 50 percent, however, that $1,000 bond would still have a principal of $1,000. Find more details about TIPS at Treasury Direct.
Taxes. Income from TIPS comes in the form of interest payments as well as any annual inflationary increase in the principal value of the bond. These gains are exempt from state and local taxes but not federal taxes. For most people, this means TIPS should be held in a tax-advantaged retirement account. (more)
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