Securities protected from inflation are attractive to some

Q. I’ve heard about Treasury Inflation-Protected Securities, or TIPS. What are they? Are they safe investments with a healthy rate of return? What are their advantages, disadvantages and restrictions? How does one invest in them? – Wayne P.

A. In 1997, the U.S. Treasury added TIPS to the list of debt securities it sells to finance government spending. They’re popular with many investors because they offer a true inflation hedge. Here’s how they work:

Like all treasuries, TIPS are sold using an auction process, which fixes the interest rate that they will pay until maturity. Interest is paid semiannually, based on the principal value. For example, a $5,000 bond paying 5 percent will pay $250 annually ($125 semiannually). TIPS are sold with five-, 10- and 30-year maturities.

But unlike other treasuries, the principal value of TIPS adjusts up or down, based on changes in the Consumer Price Index. So if we have inflation, the principal value of TIPS goes up. If we have deflation, it goes down. The dollar amount of the interest payment will go up and down based on the change in the principal value. For example, if a $5,000 TIPS paying 5 percent adjusts to $6,000, it will pay $300 annually ($150 semiannually). At maturity, TIPS are redeemed at the adjusted or original value, whichever is greater.

TIPS are direct obligations of the U.S. government. This means the timely payment of interest and principal at maturity is guaranteed by its full faith and credit. Only treasuries and securities issued by the Government National Mortgage Association offer this exceptional level of safety. This is why they are so attractive to investors.

Because TIPS offer inflation protection, they pay less interest than treasuries that don’t. For example, the Treasury auctioned five-year notes at 2.54 percent on April 30. On the same date, it auctioned five-year TIPS at 0.55 percent. Ultimately, the total return on the TIPS may or may not exceed that of the five-year note, depending on changes in the level and direction of inflation.

Investors who want to invest in TIPS must understand the tax implications. As always, interest received is taxed as ordinary income for federal income tax purposes, but exempt from state and local income taxes. But in the case of TIPS, any upward adjustment is taxed as ordinary income, too, even though no cash is actually received. This may pose a problem for some investors, but not others, like retirement plans, which are tax-sheltered.

You can buy TIPS at auction using Treasury Direct with a minimum investment of $100 and multiples of $100 thereafter. Or you can buy them at auction or in the secondary market using a bank or broker/dealer, but their minimums may be higher. And you can sell TIPS at their current market price using Treasury Direct, a bank or broker/dealer. That said, many investors prefer TIPS mutual funds, given the bookkeeping complexities.

You can learn more about TIPS by visiting TreasuryDirect.gov.