Investing Assets & Markets Bonds How Treasury Inflation-Protected Securities Work The Basics of TIPS By Thomas Kenny Thomas Kenny Thomas Kenny is an expert on investing, including bonds, ETFs, and mutual funds. He has more than 25 years of experience in the finance industry and is a partner and co-founder at Boston Investor Communications Group, a communications company for mutual fund and other investment industry providers. learn about our editorial policies Updated on October 26, 2021 Reviewed by Robert C. Kelly Reviewed by Robert C. Kelly Robert Kelly is managing director of XTS Energy LLC, and has more than three decades of experience as a business executive. He is a professor of economics and has raised more than $4.5 billion in investment capital. learn about our financial review board Share Tweet Pin Email In This Article View All In This Article How TIPS Work An Example Price Fluctuation Risks Frequently Asked Questions (FAQs) Definition Treasury inflation-protected securities (TIPS) are a form of U.S. Treasury bond designed to help investors protect against inflation. They are indexed to inflation, have U.S. government backing, and pay investors a fixed interest rate as their par value adjusts with the inflation rate. Photo: Greg Hinsdale / Getty Images Treasury inflation-protected securities (TIPS) are a form of U.S. Treasury bond designed to help investors protect against inflation. They are indexed to inflation, have U.S. government backing, and pay investors a fixed interest rate as their par value adjusts with the inflation rate. Key Takeaways Treasury inflation-protected securities pay out in two ways: based on an increase in the consumer price index (CPI) and the yield above inflation.They can lose value when the CPI drops but never to the point where they’re worth less than their face value.Treasury inflation-protected securities will continue paying out twice a year until they mature.TIPS can be owned and held within exchange-traded funds (ETFs) and/or mutual funds. They pay a fixed interest rate. How TIPS Work Like regular Treasury bonds, TIPS pay interest twice a year based on a fixed rate. They differ from ordinary Treasuries in that the principal value of TIPS adjusts up and down based on inflation as measured by the consumer price index (CPI). The rate of return that investors receive reflects the adjusted principal. An Example The best way to understand how TIPS work is by example. TIPS pay interest semi-annually, but for the purposes of simplicity, the following looks at how the value of the bond changes in each calendar year. Suppose the Treasury issues an inflation-protected security with a $1,000 face value and a 3% coupon. In the first year, the investor receives $30 in two semi-annual payments. That year, the CPI increases by 4%. As a result, the face value adjusts upward to $1,040. In year two, the investor receives the same 3% coupon, but this time it’s based on the new, adjusted face value of $1,040. The result: instead of receiving an interest payment of $30, the investor receives interest of $31.20 (.03 times $1,040). In year three, inflation drops to 2%. The face value rises from $1,040 to $1060.80, and the investor receives interest of $31.82. This process continues until the bond matures. In this way, the TIPS’ payout consists of two parts: the increase in CPI and the “real yield,” that is, the yield above inflation. Once the bonds mature, investors receive either the adjusted, higher principal or their original investment, whichever is greater. As a result, investors cannot ever receive less than the face value of the bond, even in the rare case of deflation (falling prices). Price Fluctuation Risks Investing in TIPS may seem very compelling at first glance, but investors should consider three issues: During the life of a TIPS bond, its principal declines in periods of deflation, or falling CPI. The increase in face value of the bond triggers taxes each year, which not only eats into the element of inflation protection but also creates additional tax work. For this reason, individual TIPS bonds make more sense for a nontaxable account. While TIPS don’t carry credit risk—the risk of default by their issuer: the U.S. government—their prices do fluctuate between their issue dates and maturity dates. TIPS are also highly sensitive to changes in prevailing interest rates. As a result, you could lose money if you were to sell a TIPS prior to its maturity. In that case, the loss of principal could far outweigh the benefit of inflation protection. If you intend to hold the bond until maturity, however, that isn’t an issue. Principal fluctuations are much more likely to be an issue if you own a mutual fund or exchange-traded fund (ETF) that invests in TIPS. In that case, rising interest rates will lead to a substantial decline in the value of the fund’s share price. Unlike an individual bond, mutual funds have no set maturity dates, so you have no guarantee of having the full value of your principal returned. Frequently Asked Questions (FAQs) Where can I buy Treasury inflation-protected securities? You can purchase TIPS from the U.S. Treasury at TreasuryDirect if you set up an online account. Alternatively, you can also buy them through a bank or broker. How are Treasury inflaton-protected securities calculated? Interest on TIPS is calculated based on the rate of inflation every six months. To calculate the current value of a security you already own, you can find its issue period on the chart at TreasuryDirect. Click the link for your period, then find your issue date on the table at the following page. Multiply your original principal by the index rate listed to find your current value. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. Treasury Direct. "Treasury Inflation-Protected Securities (TIPS)." Accessed April 30, 2020. Treasury Direct. "TIPS: Rates & Terms." Accessed April 30, 2020. Treasury Direct. "TIPS: FAQs - What Happens To TIPS If Deflation Occurs?" Accessed April 30, 2020. Treasury Direct. "TIPS: FAQs - Can I Be Taxed for TIPS Earnings Before I Receive Payment for Those Earnings?" Financial Industry Regulatory Authority. "TIPS and STRIPS." Accessed April 30, 2020 PIMCO. "Understanding Treasury Inflation‑Protected Securities (TIPS)." Accessed April 30, 2020. Fidelity Investments. "Bonds vs. Bond Funds." Accessed April 30, 2020.