With Tips, you principal amount adjust according to inflation. It is adjusted using the Consumer Price Index or CPI. The CPI basically measures the change in cost of living such as the prices paid for certain products from month to month. In escense, when the CPI goes up, your principal amount will increase. The opposite is also true.

In addition, Tips pay a bi-annual return of a specified percentage based on the amount of time that you agree to leave your money in. Although this may only be a couple percent, you must look at the overall return of the adjusted principal and the given interest rate.

Author: John Zinsky

In times when inflation is threatening the value of your dollar you want to hedge against its effects by putting your money in the right places.  One way of doing this is to add TIPS to your portfolio.

TIPS is an acronym for Treasury Inflation Protected Securities. TIPS are issued by the US Department of Treasury and pay interest twice a year. Owning them is virtually risk free since they are backed by the US government. They are sold in increments of $100 for either 5, 10, or 20 year periods and can be purchased directly through the US Treasury at www.treasurydirect.gov.  They can also be purchased through a bank or broker.

Here’s how they work:

The US treasury adjusts the principal amount that you invest up or down according to the CPI. The CPI is an inflation indicator that  is released monthly and shows a calculation of the average prices a household pays for goods and service compared to the previous month. The treasury also uses the CPI to calculate the amount to be paid as the maturity date is reached. As the CPI increases in an inflationary period your principal increases. The inverse is also true. As the CPI decrease your principal decreases. In a period of deflation where your principal falls below what you originally paid for your security you will receive your original principal.

These securities also pay bi-annual interest. The interest can be calculated by taking your adjusted principal (principal after CPI is factored in) and multiplying it by one half the interest rate as determined at the time of purchase.

For example on January 30, 2009 a 20 year TIPS yield was set at 2.5%.( the 20 year TIPS rate is set in January and July) If you were to put $2000 in 20 year TIPS with an interest rate of 2.5% and the CPI rises 3% your bi annual interest payment is calculated using the following equation:

$2,000 *1.03= $2,060

$2,060 * 2.5% / 2 = $25.00

Your 6 months would be $25.00.

Now the year is 2029 and your security is about to mature. Let assume that inflation rises  at a rate of 5% for the next 20 years. Using compound interest the payment at the maturity date would be $5.306.60

When buying TIPS please remember to keep them in a tax deferred IRA account because you are required to pay tax on both the principal and interest.  Additional information can be found at http://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm