Treasury-Inflation Protected Securities (TIPS) pay higher yields if inflation increases. Thus, they offer a hedge against inflation, perhaps the greatest risk faced by bondholders.
Suppose you buy $20,000 worth of TIPS when they’re issued, with a yield of 2.5 percent. That’s $500 in interest a year.
If inflation for the first year is 3 percent, the value of your bonds would rise from $20,000 to $20,600, an increase of 3 percent. Now your 2.5 percent interest rate would be on $20,600 worth of bonds so you’d get $515 in interest. This process would continue until you sell your TIPS or redeem them at maturity.
The catch? TIPS only pay the interest each year but the uncollected principal buildup is taxable as well. In the above example, you’d collect $515 in interest yet you’d be taxed on $1,115 of total income from these bonds. Thus, it’s better to hold TIPS in a tax-deferred retirement account such as an IRA.
