Financial Freedom 101

TIPS stand for Treasury Inflation-Protected Securities, they provide protection against economic inflation. The principal of TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.

TIPS are a popular asset for protecting your portfolio from inflation, and profiting off of it. TIPS pay interest every 6 months on a fixed rate. Although, the interest payment amounts can vary since the rate is applied to the adjusted principal or value of the bond.

The Benefits of TIPS

Tips are stable investments with low volatility compared to investing in a stock. The prices of TIPS fluctuate just like bonds do. TIPS are low risk because they are treasury bonds backed by the US government. TIPS are indexed for inflation so there’s almost no inflation risk as long as your personal rate of inflation is close to the Consumer price index rate.

TIPs are considered one of the safest investments in the world. They offer diversification for any investment portfolio because they have little correlation with most other investments within a portfolio. They are exempt from state and local taxes, and investors are guaranteed a real rate of return because the principal investment is adjusted for inflation. The investor knows he will receive his stated interest percentage (real return) plus the adjustment for inflation.

TIPS are a conservative approach to having an inflation hedge. There are many approaches to hedging for inflation, but none offer the safety and stability of TIPS.

The Risks of TIPS

Although they are low-risk investments, there is still some possible risks that you have to be aware of. Price fluctuation could affect your tips  their market prices can move considerably with changes in real interest rates. That means that the share price of a mutual fund investing in TIPS can vary significantly over the short term. The risk of deflation is another thing that will make you lose money on TIPS. If we were in a long period of deflation tips would lose significant value. Although TIPS and other fixed income investments work similar to conventional bonds, investors should understand that TIPS are NOT guaranteed investments. Although TIPS are indexed to inflation, they are not guaranteed to increase in value during inflationary periods.

The Bottom Line

TIPS are a great way to diversify your long term portfolio, especially with interest rates at 0% right now. TIPS investing will be easy and highly beneficial to your portfolio. TIPS may not be the most exciting investment around, but they are the only securities that provide a guaranteed real rate of return by the U.S. federal government. TIPS provide a positive inflation adjusted return for long term investors, by combining TIPS with nominal bonds, the fixed-income portfolio should become less volatile, as should the portfolio as a whole.