TIPS

Treasury Inflation-Protected Securities (TIPS) are U.S. Treasury bonds whose principal adjusts with the Consumer Price Index (CPI) while the coupon rate stays fixed, so interest payments rise and fall with inflation.

TIPS are the exam’s standard answer to one question: which investment addresses inflation, or purchasing-power, risk? Every other tested fact follows from the single structural choice that makes that answer correct.

Which part moves

The coupon rate is set at auction and never changes. The principal is indexed to the CPI and changes. Because a fixed rate is applied to a moving principal, the dollar amount of each semiannual interest payment moves even though the rate does not.

That sentence is the whole topic, and the wrong answers are built by reversing it.

Worked example

An investor buys a TIPS with a $1,000 original principal and a 3% coupon. Treasury interest is paid semiannually, so each payment is 3% ÷ 2 = 1.5% of the current principal. At issue, that is 1.5% × $1,000 = $15.00 every six months.

Inflation runs and the adjusted principal reaches $1,060. The next payment is 1.5% × $1,060 = $15.90. The rate is still 3%. Two common wrong answers sit nearby: $15.00 comes from applying the rate to the original principal, and $31.80 comes from using the full annual rate on the adjusted principal.

Now the floor. Suppose deflation later pushes the adjusted principal to $970 by the maturity date. The investor receives the greater of the adjusted principal or the original par, so the repayment is $1,000, not $970. Deflation can shrink the interest payments along the way, but it cannot cut the final principal below par.

The exam trap

The first trap is the rate-versus-principal flip. Any answer saying the coupon rate rises with the CPI is wrong, however reasonable it sounds.

The second is tax. Each year’s upward principal adjustment is taxable as interest income in the year it occurs, even though the investor receives no cash until maturity. This is phantom income, the same problem STRIPS create through accretion, and it is why both are often held in tax-deferred accounts. Like all Treasury interest, TIPS interest is exempt from state and local tax.

The third is risk vocabulary. TIPS address purchasing-power risk. They do not remove interest-rate risk: their market price still falls when real yields rise, and a TIPS sold before maturity can be sold at a loss. A question offering “eliminates interest-rate risk” is testing that gap.

Current-Fact Watch: TIPS. The mechanics above (CPI-indexed principal, fixed coupon rate, par floor at maturity, annual taxation of the inflation adjustment) are set by the security’s structure and are stable. What changes constantly is the real yield set at each auction and the CPI itself, so treat any specific TIPS yield or inflation figure in prep material as an illustration, never as a fact to memorize.

Related distinctions

Compare a plain long-term Treasury bond, which pays a fixed number of dollars until maturity and is therefore the security most exposed to inflation. Compare STRIPS and zero-coupon bonds, which pay nothing along the way and remove reinvestment risk instead. And compare a fixed annuity, whose guaranteed level payment is the classic distractor in inflation questions: guaranteed in nominal dollars is precisely what inflation erodes.

Check yourself

1. A TIPS has a 4% coupon and an adjusted principal of $1,050. What is the next semiannual interest payment?

   1. $20.00
   2. $21.00
   3. $42.00
   4. $40.00

   Show answer and explanation

   Answer: B. $21.00.

   4% ÷ 2 = 2%, and 2% × $1,050 = $21.00. Choice A applies the semiannual rate to the original $1,000; choice C uses the full annual rate on the adjusted principal.

2. Over the life of a TIPS, cumulative deflation leaves the adjusted principal below the original par value on the maturity date. What does the investor receive?

   1. The adjusted principal, because the security tracks the CPI in both directions
   2. The original par value, because TIPS repay the greater of the two
   3. The original par value plus all inflation adjustments ever recorded
   4. The adjusted principal, plus a Treasury rebate for the shortfall

   Show answer and explanation

   Answer: B. The original par value, because TIPS repay the greater of the two.

   The par floor applies at maturity. Choice A is the trap: the CPI does move the principal down during the security's life, and the interest payments shrink with it, but the final repayment is never less than par.

Practice it: government-debt practice questions