TIPS
While strictly a type of bond, the
unique characteristics of Treasury inflation-protected
securities, or TIPS, puts them in an asset class of their
own.
 TIPS
are inflation-indexed bonds and notes that
are issued by the U.S. Treasury. Like traditional Treasurys,
TIPS pay a fixed rate of interest. But what makes TIPS
different is that the principal value of the bond, to which
the interest rate is applied, is pegged to the current
rate of inflation. So if inflation rises throughout the
term of the bond, so will your interest payments.
For example, let's say you buy a $10,000 inflation-indexed
bond with a yield of 3% per year. If the inflation rate
is 4% the first year you hold the bond, the bond principal
will increase to $10,400 and your first annual interest
payment will rise from $300 to $312 (or 3% of $10,400).
On the other hand, during a rare period of deflation,
your interest payments would drop.
At the end of the bond's term, you are repaid the inflation-adjusted
principal. So, if you bought a $10,000 bond and inflation
rose 8% during the life of the bond, you would receive
$10,800 at maturity. However, in the case of deflation,
you never receive less than what you paid for the bond.
So if deflation occurs and decreases your interest payments,
you'll still receive your full principal back at maturity.
While traditional bonds pay slightly higher rates of interest,
the real
rate of return on TIPS, after accounting for inflation
can outpace traditional bonds.
Another advantage of allocating some of your assets to
TIPS is that they can lower the overall volatility of your
portfolio. That's because TIPS have a low correlation to
other types of bonds, since they respond differently to
inflation. They also have a lower correlation to stocks
than traditional types of bonds. This means that their
values don't necessarily move in tandem with other, more
traditional, types of investments.
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Professor
Roger 