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Inflation-Indexed Treasury Notes

Treasury inflation-indexed notes, popularly known as TIPS for Treasury Inflation-Protected Securities, are a special type of Treasury note.  As with other notes, the owner of an inflation-indexed note receives interest payments every six months, and a return of principal when the security matures.  But unlike regular notes, the interest and principal for TIPS are adjusted for inflation. 

Principal

The only TIPS now sold by the Treasury is a 10-year note.  The principal value is adjusted based on the Consumer Price Index for All Urban Consumers (CPI-U), published monthly by the Bureau of Labor Statistics (BLS). 

At maturity the Treasury redeems the note at its inflation-adjusted value or its original par value, whichever is greater.  In all likelihood, inflation will occur over the life of the security and the redemption value will be greater than the original par value.  If there were a net deflation over the holding period, the final payment would be the original par value, which means there can be no loss of principal due to deflation.

Interest 

Semi-annual interest payments are based on the inflation-adjusted principal at the time the interest is paid.  Each interest payment is calculated by multiplying the inflation-indexed principal (whether greater or less than the par value) by one-half the coupon rate for that note.

Like other notes, TIPS have coupon rates that are derived from the open market bids received by the Treasury.  In other words, the TIPS coupon is a market rate.  If inflation occurs throughout the life of the note, every interest payment will be greater than the previous one.  In the unlikely event of deflation during a six-month period, the interest payment for that period will decrease. 

Purchase Options 

TIPS are sold three times a year from TreasuryDirect, an auction in July, and reopenings in October and January.  In a reopening, additional amounts of the previous July-issued notes are sold rather than new issues. The reopened notes retain the maturity date and coupon rate of the July notes.  However they have a different issue date, which creates a shorter term to maturity, and usually a different purchase price. 

TIPS are also sold through private financial institutions who will hold the securities on behalf of the purchaser in the commercial book entry system.  If bought through TreasuryDirect, there is no fee and the account is held directly with the Treasury. 

Tax Matters 

Like other Treasury notes, TIPS are subject to federal income tax, but exempt from state and local income taxes.  In any year when the principal of the security grows, the gain for that year is reportable income on the federal return even though one won't receive the inflation-adjusted principal until the note matures.  If one holds TIPS in TreasuryDirect, he will receive two tax statements each year: an IRS Form 1099-INT showing the interest, and a 1099-OID showing the increase or decrease in the principal value of the security.
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