Tuesday, January 12, 2010

What are treasury inflation protected securities(or tips)?

Treasury Inflation-Protected Securities (or TIPS) are bonds that are issued by governments. The advantage that you get with this security is that the principal of the bond is adjusted yearly with inflation.Thus the principal increases every year and its real value will remain the same. This is contrary to other bonds whose nominal value remain constant whereas their real value decreases.

Since the principal is adjusted yearly with inflation, its value will increase and as a result the coupon payment will increase. This bond is thus a good investment in times of high inflation. The value of your investment will keep its real value with time. This compares to the normal bonds whose principal and the coupon remain the same thus losing its real value with time.

However in case of deflation like in Japan, where inflation turns negative, the value of the principal and coupon decrease with time. In this case a normal bond would have maintain its nominal value but would have its real value increasing.

So investing in tips is just about deciding whether the future will bring deflation or inflation.

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