TIPS, Bonds and Inflation

Treasury Inflation Protected Securities, or TIPS bonds, are one of the few bonds protected against inflation. When you purchase a bond with a guaranteed payout after maturity, this payout may actually represent a loss if inflation was high during the bond's active life. The government offers TIPS as a way to hedge against that possibility and assure you make a profit regardless of inflation prior to maturity.

Interest Rate on TIPS Bonds

The interest rate on the bond is set when it is sold. The principal sum, though, rises or falls with the inflation rate. This means your initial investment will be adjusted for inflation, and you will receive interest based on that sum. Inflation is accounted for on your principal twice a year. This means the sum will be adjusted multiple times annually, and the interest you receive is also paid twice a year. You cannot exactly determine the interest rate you will receive, then, on a TIPS bond. 

Tax on TIPS Bonds

You will have to pay tax on this distribution, and you will also be charged tax on the principal sum if it has risen due to inflation. Unfortunately, this could mean you are paying taxes on money you have not yet received. The good news is that these bonds, like some other forms of government bonds, are tax exempt when they are finally redeemed. So, even though it may feel as though you are losing money while you hold the bond, you will come out on top in the end. Some investors place TIPS bonds in accounts that are tax-deferred for this reason. Tax-deferred accounts include some 401k and IRA accounts. Unfortunately, when you do this, the bonds lose their eventual exempt status. You will have to pay the standard tax charged upon withdrawal if you elect this option.

Protection from Deflation

It is rare to have deflation over the life of a bond. However, some bonds that mature quickly may see an overall period of deflation first. With a TIPS bond, this means your principal sum would have been reduced significantly through the inflation adjustment. Thankfully, the bonds are guaranteed to pay either the initial principal or principal adjusted for inflation, whichever is higher. If the adjusted principal is actually lower due to a rare period of deflation, you do not have to be concerned the government may simply repay you the lower amount when the bond matures.

TIPS vs. I-Bonds

I-Bonds are another type of inflation protected bonds the government offers. They are very similar to TIPS bonds because they are tax exempt and offer protection from inflation. The main difference is how this inflation protection is determined. With an I-Bond, the interest rate on the bond is constant, and the principal is constant. There is then a second interest rate that accounts for inflation assessed each year. This second interest rate never adjusts the principal, but it does allow for protection by adjusting the total interest earned on the bond during a period of high inflation. If deflation occurs, the interest rate will drop, but it can never drop below zero.

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