Federal Reserve Bank of Cleveland
Press Release

For Release: October 17, 1997
Contact: June Gates, 216/579-2048

TIPS for Safer Investing

Investors who bought U.S. Treasury securities in the 1960s saw the value of their investment erode with the high inflation rates of the 1970s. Investors seeking to shelter their holdings from inflation may want to consider adding Treasury Inflation-Protection Securities (TIPS) to their portfolios. Numerous investment vehicles -- including real estate, gold and stocks -- are touted as hedges against inflation. However, TIPS are the first U.S. government securities that provide guaranteed protection against the loss of purchasing power that accompanies a rise in the price level.

According to Kevin H. Sargent and Richard D. Taylor, senior research assistants at the Federal Reserve Bank of Cleveland, TIPS are structured like the real-return bonds currently issued in Canada. The value of the principal is adjusted for inflation each day, using the Consumer Price Index (CPI) as a benchmark. Every six months, a fixed-rate coupon is issued, with its payment based on the revised principal.

In a recent Economic Commentary, Sargent and Taylor explain that the principal of a TIPS grows at the same rate as inflation; thus, it maintains its real value in terms of the CPI. The fixed-rate coupon also rises in proportion to the increase in the principal. If deflation occurs, the principal and coupon payment are adjusted down in accordance with the falling CPI. The principal is returned to the investor upon maturity, fully adjusted for inflation or deflation. However, if deflation reduces the principal below the security’s stated value at issuance, the investor will receive the issued value back from the Treasury.

TIPS were initially auctioned on January 29, 1997, and the Treasury intends to issue them in several maturities ranging from one to 30 years. Although returns on TIPS are expected to be lower than on traditional Treasury securities, the authors postulate that some people will gladly forgo higher returns for the guarantee that their savings will keep pace with inflation.

TIPS are not without risk, however. Because the market for them is not yet fully developed, and the term structure is incomplete, some purchasers may have concerns about their ability to liquidate the securities. In addition, TIPS are subject to a unique tax treatment: Investors are taxed on both the coupon payment and the inflation adjustment to the principal. Since investors receive the fixed percentage coupon but not the capital gain on the principal, their tax bill may exceed the coupon payment if the inflation rate is high enough. (This is a moot concern if TIPS are held in a tax-deferred account such as a 401(k) or IRA.)

The performance of TIPS depends on the actual rate of inflation relative to expectations. If actual inflation ends up being less than what the market anticipates, TIPS will underperform conventional Treasury securities. Conversely, if actual inflation exceeds expected inflation, TIPS will pay a higher return than conventional Treasuries.

Who is likely to invest in TIPS? Perhaps conservative investors who do not want to risk their money in the stock market, but still want to beat inflation. Individuals who wish to draw income from their investment while preserving their principal are also good candidates. And, because of the tax implications, TIPS will likely attract managers of pension and annuity funds.

(This document is not intended to provide investment advice. Those who choose to invest in TIPS do so at their own risk.)

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