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T.I.P.S or Treasury Inflation Protected
Securities are a relatively new and interesting investment vehicle that any astute investor should
investigate. T.I.P.S. are issued by the U.S.
Treasury. The payments of their interest and
principal are made and backed by the U.S. government.
T.I.P.S. are so named because the principal value is protected from
inflation. The return investors can expect from T.I.P.S. is in two forms:
·
Interest paid by the borrower (the
federal government) at a constant rate semi-annually over the life of the bond.
·
Increases in the principal value of the
bonds based on the level of inflation over the life of the bond.
Interest paid by T.I.P.S. is like that
of conventional bonds. The increases in
principal value, however, need a little explaining. When
the bond is first issued the principal value or par value is $1,000 per bond. Over the life of the bond the principal value
changes with the consumer price index (CPI), a common measure of inflation. If the investor bought a 10-year bond when it was
originally issued and held it to maturity and inflation averaged 2% per year, the
principal the investor would receive at maturity is $1,220 per bond. An investor in a bond without inflation protection
would receive $1,000. While the principal value of T.I.P.S. goes up, and sometimes down,
with changes in consumer prices, the principal value never goes below $1,000 or par.
In addition, the interest paid every six-months is interest on the
new adjusted principal value. The interest rate itself is does
not change, but the dollar amount paid out does due to the higher
adjusted principal value.
The interest on T.I.P.S. is subject to
federal income tax just like any other taxable bond.
Any increases in the principal value due to changes in the CPI are also
taxable in the year of the increase, not at maturity.
Because of this feature of taxing an increase in principal when no income is
received, we typically hold T.I.P.S. only in tax-deferred accounts like IRAs, 401k's,
403(b)s and Profit Sharing accounts.
At the current time inflation does not
appear to be a problem. As we all know events
happen in cycles. And, often when something
seems least likely to occur, that is when that event does happen. Even though inflation is not a problem now, that
could change in the future. The advantage of the
T.I.P.S. are that they offer a hedge against inflation.
T.I.P.S. have a place in most
tax-deferred portfolios. To learn more about
T.I.P.S. or to find out how they might fit into your investment plans, please contact Lyon
Capital Management.
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