Treasury Inflation-Protected Securities (TIPS) are like treasury bonds, but with a few key differences.
A treasury bond is one issued by the U.S. federal government, which needs to raise money for all of its objectives. The interest rate, or risk-free rate, is low because of the government’s exceptional credit. Usually, treasuries offer a slightly higher yield than the rate of inflation so that investors will buy the bonds. Recently, treasury yields have been falling below the rate of inflation, as the Federal Reserve keeps treasury prices high in order to keep interest rates low to stimulate the economy.
So some investment strategists and wealth managers have been recommending that investors allocate money to TIPS for the defensive portion of their portfolios, especially as all the recent stimulus potentially creates inflation down the road.
The idea of TIPS is to protect investors against inflation. If an investor owns a regular 10-Year Treasury bond that yields 1% and inflation starts running at 1.5%, the investor is losing value.
But if this investor owns TIPS instead, he or she will not lose any value against inflation.
Here’s how TIPS are structured:
An investor buys a TIPS at $100 for an interest rate of 0.5%. If inflation runs at 1.5%, the principal is no longer $100, but rather $101.50. The principal is adjusted for inflation. The 0.
5% interest rate is no longer 50 cents. It’s adjusted for the new principal and is now 0.5% of $101.50, slightly more than 50 cents. So an investors’ capital put into TIPS never loses buying power in the economy.
Now to see the downside to TIPS and whether you should buy them, watch the quick video above.