Part 1: What are TIPS, How TIPS Work & Protect Against Inflation, Detailed Example, How to Buy & Sell TIPS
Part 2: Pros and Cons of Investing in TIPS, Who Should Invest in TIPS
Introduction to TIPS for Kids and Teens
This video explains the concept of TIPS in a simple, concise way for kids and beginners. It could be used by kids & teens to learn about Treasury Inflation-Protected Securities, or used as a money & personal finance resource by parents and teachers as part of a Financial Literacy course or K-12 curriculum.
Suitable for students from grade levels:
- Kindergarten
- Elementary School
- Middle School
- High School
The topics covered are:
- What are TIPS
- How exactly do TIPS protect against inflation
- An example how how TIPS work
- How can you buy and sell TIPS
- The advantages of investing in TIPS
- The disadvantages of investing in TIPS
- Who should invest in TIPS
What are TIPS?
TIPS (or Treasury Inflation-Protected Securities), are a type of U.S. government bond that are designed to protect investors from inflation.
Unlike regular bonds, TIPS’ principal (also known as par value or face value) increases alongside inflation, ensuring your investment maintains its purchasing power over time.
They are issued in 5, 10 or 30 year maturities and pay a fixed rate of interest every six months on the adjusted principal.
TIPS are backed by the US government, meaning there’s no risk of losing the principal – making them one of the safest investments.
How exactly do TIPS protect against inflation? How TIPS work?
TIPS match the Consumer Price Index (CPI) that tracks the everyday cost of living using a basket of goods and services.
When the index rises indicating inflation, so does TIPS’ principal amount. Similarly, when the index falls indicating deflation, so does the TIPS’ principal amount.
Since the interest is paid on the adjusted principal amount, this allows TIPS to provide higher interest during periods of high inflation, as well as maintain the value of your investment no matter how high inflation is.
At the same time, although the interest payment can be lower if the adjusted principal falls below the original price of TIPS, the principal amount itself is protected as the investor will never receive less than the original price when redeemed at maturity, no matter how low the adjusted principal is.
Can you give me an example?
Suppose you own $10,000 of TIPS at an interest rate of 5%. If there is no inflation or deflation that year, you will receive $500 in interest for that year.
But if the inflation is 3%, the principal will be adjusted to $10,300 and you will receive an interest of 5% on that, which is $515. On the other hand, if there is deflation of 2%, the principal will be adjusted to $9,800 and you will receive $490 in interest.
At the time of maturity, you will receive your original investment of $10,000 if the current adjusted principal amount is lower, say $9,800.
And if the adjusted principal amount is higher than the original $10,000, say $10,300, you will receive $10,300.
How can I buy and sell TIPS?
TIPS can be bought directly from the U.S. government at TreasuryDirect.gov or in the secondary market.
You can also invest in mutual funds or Exchange Traded Funds (ETFs) that focus on TIPS, which can offer an easier way to add TIPS to your portfolio.
They can be sold in the secondary market, or redeemed at the time of maturity. When redeemed, you would get the current or the original principal amount, whichever is higher.
What are the advantages of investing in TIPS?
The biggest – and most obvious – advantage of TIPS is their protection against inflation, which means your money retains its value no matter how high inflation is. You also get interest on the inflation adjusted principal amount.
They also offer deflation protection. This means that at the time of maturity, you will get the original or the inflation adjusted principal, whichever is higher.
This guarantees that you will never get less than the original principal.
TIPS are tradable on an exchange, so you can sell them at any time if you are in need of money.
Also, since TIPS are backed by the U.S. government, there is no risk of losing the principal.
And like all US government securities, the interest from TIPS is exempt from state and local income tax – you only need to pay federal income tax.
Are there any disadvantages of TIPS?
The biggest disadvantage of TIPS is what’s known as ‘phantom income’.
The increase in TIPS principal based on inflation is treated as taxable income. This means you must pay federal income tax on this principal increase even though you didn’t actually receive that money.
A good way to offset this is to invest in TIPS through a tax-advantaged investment account such as a 401k or IRA.
Since TIPS offer inflation protection, their interest rate is generally lower than that of other US Treasury securities, putting them at a disadvantage during times of low inflation.
While TIPS don’t carry any credit risk as they are guaranteed by the US Government, they do carry interest rate risk: meaning when the interest rates are rising, their market price falls like any other bond.
Also, during deflationary times, TIPS’ value as well as the interest earned go down. So if an investor sells TIPS in the secondary market, they may get less than what they originally paid.
Who should invest in TIPS? Are TIPS the right investment for me?
TIPS are a great choice for investors who want to preserve the value of their savings, especially in times of rising prices such as recent years. This makes them an attractive investment for retirees.
However, due to their virtually risk-free nature, TIPS offer much lower returns than other higher-risk investments such as stocks. So if you’re young and investing for growth, alternatives like the stock market are a better choice.
If you do choose to invest in TIPS, using an ETF that focuses on TIPS could be a convenient way to do so.
