TIPS: Return of Your Money

Jul. 7.10 | About: iShares TIPS (TIP)

After the market volatility of the last two months you may have some cash sitting on the sidelines. A safe place to park money looks better and better to many investors as evidenced by the recent dip below 4% on 10-year Treasuries. Interest rates can only drop this low when fear helps investors remember the most important equation is “Return of my money…then return on my money.”

One place you might look is “TIPS” or Treasury Inflation Protected Securities. TIPS are sold in $100 increments, and can be purchased from your local bank, brokers, or if you prefer directly from the U.S. Treasury. TIPS are sold with maturities of five, ten, and 30-years. A bank or broker will charge a commission on the sale. There is no commission or fee if TIPS are purchased direct from the Treasury.

TIPS face values are adjusted based on inflation as measured by the Consumer Price Index (NYSEARCA:CPI), and pay interest every six months. If you buy $1,000 dollars face value in TIPS that pay 3% interest, on the six month anniversary the face value will be adjusted up or down (with inflation) and then pay the 3% interest on that adjusted amount.

If there is no inflation during the last six months, the face value would remain the same and the interest payment would be $15 dollars. If the CPI measured 10% deflation, the face value would be adjusted to $900 and the interest would be calculated on this amount, paying $13.50 ($900 x 0.03 = $27 / 2 = $13.50). If inflation were 10% the face value will be adjusted to $1100 and the interest would be calculated on this amount, paying $16.50 ($1100 x 0.03 = $33.00 / 2 = $16.50).

The beauty of TIPS? You won’t lose money if you hold them to maturity. The government will pay you the higher face value from inflation, or in the case of deflation they will still pay the ORIGINAL face value. This means you may receive less interest because of deflation but will always receive at least your original capital invested back.

The Fed has been fighting deflation, trying to kick start the economy with low interest rates and purchases of securities. As all that “new” money makes it into the system and banks start lending it, there is little doubt we will face inflation. Inflation will probably accelerate before the Fed can withdraw “excess liquidity” from the market. With high unemployment there is pressure to let the economy heat up, rather than withdraw any stimulus.

One tax point to be aware of is that the interest payments and any increase in face value are taxable in the year it occurs. TIPS are exempt from state and local taxes but subject to Federal taxes. TIPS can be held in tax exempt retirement accounts, as well as by corporations, trusts, estates, and partnerships.

Five-year TIPS are auctioned in April and October, Ten-year TIPS are available in January, March, July, September and November. You can buy through a broker or bank out of their inventory at other times.

For more information, you can read more at the TreasuryDirect website on TIPS: Rates & Terms.

You can also invest in a mixed bag of TIPS instruments through the etf TIP. TIP charges a 0.20% administration fee, which will lower your return if you are holding for an extended period of time. TIP pays interest monthly and currently yields 3.84%. The Ex-dividend date is generally the first of the month, with interest payed a week later. This can be an excellent place to "park" money while we are riding out the turbulence in the market. The iShares Page on TIP Bond Fund etf provides more information.

Disclosure: No position