Treasury Inflation-Protected Securities

Treasury Inflation-Protected Securities (TIPS) are the inflation-indexed bonds issued by the U.S. Treasury. The principal is adjusted to the Consumer Price Index, the commonly used measure of inflation. The coupon rate is constant, but generates a different amount of interest when multiplied by the inflation-adjusted principal, thus protecting the holder against inflation.

Federal Income Tax Treatment: The interest payments from these securities are taxed for federal income tax purposes in the year payments are received (payments are semi-annual – every six months) as one would expect. The inflation adjustment credited to the bonds is also taxable each year, which might not be expected. This tax treatments cause an interesting effect: Even though these bonds are intended to protect the holder from inflation, the cash flows generated by the bonds are actually inversely related to inflation until the bond matures. For example, during a period of no inflation, the cash flows will be exactly the same as for a normal bond, and the holder will receive the coupon payment minus the taxes on the coupon payment. During a period of high inflation, the holder will receive the same cash flow, but will also have to pay additional taxes on the inflation adjusted principal.

The details of this tax treatment can have unexpected repercussions. An investor should seek advice from a tax advisor prior to purchasing these bonds.