TIPS bonds represent low-risk investment opportunities that have low interest rates attached to them but are protected from any inflation in the economy. This is because the United States government issues the bonds and guarantees at least the return of the original principal payment to the investor. While the interest rate on TIPS, or treasury inflation-protected securities, bonds is locked in for the duration of the bond, the principal amount rises during inflation and falls during deflation. Distributions on TIPS bonds are made twice a year based on the interest on the principal amount, but the fact that these payments are taxable represents one of the flaws of this investment opportunity.
Investors often rely on bonds for a low-risk, low-reward investment opportunity that can provide diversity to any portfolio. Inflation within the economy can cause certain bonds to become worthless or even lose money for the investor. TIPS bonds represent a remedy to this situation, as they actually grow in value with inflation and are government protected to keep the investor from losing any part of his or her original investment.
Those who purchase TIPS bonds buy them at an interest rate that is then locked in for the duration of the bonds or until they are sold. Although the interest remains the same, the distribution payments to the investor, which come twice a year, can change due to the nature of the economy. When there is inflation within the economy, the principal in the bond goes up, and when there is deflation, the principal goes down. The interest is then applied to wherever the principal stands at the time of the distribution payment.
When the bond matures, the investor is guaranteed either a return of the original principal payment or the principal at maturation plus any accrued interest, whichever is the larger amount. TIPS bonds may also be actively sold at any time, which gives them an advantage on I-bonds, which are also issued by the government and are protected against inflation. In the case of I-bonds, they must be held for at least a year, and if they are redeemed before five years, a penalty is incurred.
While TIPS bonds themselves are exempt from taxation, the semiannual distribution payments are subject to U.S. federal taxes. In addition, any rise in the principal due to inflation also represents taxable income. This can be problematic because the investors have no access to the principal while owning the bond, meaning that they must pay taxes on income that isn't really in their possession, a concept known as phantom income. Since this is the case, many investors place these bonds in tax-deferred accounts.