Treasury Inflation-Protected Securities (TIPS) are issued by the U.S. Treasury Department so they have no risk of default. Like all Treasury securities, their interest is exempt from state and local income taxes. With TIPS, though, your stated yield is much lower.
Today, an ordinary 10-year Treasury note yields about 5 percent while 10-year TIPS yield around 2.5 percent. That 2.5 percent TIPS yield, though, is misleading. With TIPS, you’re getting that 2.5 percent yield as well as an amount equal to the inflation rate.
Say inflation is 4 percent per year for the next 10 years. That’s about the historic rate, going back 30 years, and that’s what inflation is running in 2006.
With 4 percent inflation, you’d wind up with a total return of 6.5 percent a year (4 percent inflation plus a 2.5 percent yield), so you’d be better off with TIPS than with a 5 percent traditional Treasury. The higher the inflation rate, the higher your return from TIPS.
