If you are concerned about inflation, the U.S. Treasury Department has some bonds that might interest you. They're called Treasury Inflation Protected Securities, or TIPS. Issued with maturities of five, 10 and 20 years, TIPS shelter you from inflation risk because their principal is adjusted semiannually for inflation based on changes in the Consumer Price Index-Urban Consumers (CPI-U), a widely used measure of inflation. Interest payments are calculated on the inflated principal. So, if inflation occurs throughout the life of the bond, interest payments will increase. At maturity, if the adjusted principal is greater than the face or par value, you will receive the greater value.
Because they are U.S. Treasury securities, TIPS are backed by the "full faith and credit" of the U.S. government and, therefore, carry virtually no credit or default risk. Remember the trade-off between risk and reward? It holds for TIPS as well. While the TIPS investor is sheltered from inflation risk and, in fact, benefits during periods of inflation, the trade-off is that the base interest rate on TIPS is usually lower than that of other Treasuries with similar maturities. In periods of deflation, low inflation or no inflation, a conventional Treasury bond can be the better-performing investment.
You might ask, "What happens if deflation (a negative inflation rate) occurs? Would my TIP investment be worth less than what I paid for it?" No, unless you paid more than the face value of the bond. Upon maturity, the Treasury Department agrees to pay the initial face value of the bond or the inflation-adjusted face value, whichever is greater.
For more information on TIPS, see TreasuryDirect's Treasury TIPS Web page.
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