How do TIPS (Treasury Inflation-Protected Securities) mechanically work?

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AcadiFi · Accepted Answer

**TIPS** adjust principal for inflation based on the non-seasonally adjusted Consumer Price Index for All Urban Consumers (CPI-U). Coupons are paid on the adjusted principal, so both coupon payments and final repayment rise with inflation. **Mechanics:** - Issued with a fixed real coupon rate (e.g., 1.50%) - Principal adjusted daily using CPI reference index: Indexed Principal = Original Principal × (Current CPI / Base CPI at issue) - Coupon payment = Real coupon rate × Indexed Principal × (days/360 or similar) - At maturity: receive greater of indexed principal or original principal (deflation floor) **Example — Rosemont Pension Fund holds $1M TIPS issued 2026-01-15:** - Real coupon: 1.25% semi-annual - Base CPI at issue: 312.4 - After 12 months, CPI = 321.3 (2.85% inflation) - Indexed Principal = $1M × (321.3 / 312.4) = $1,028,498 - Semi-annual coupon payment = 0.625% × $1,028,498 = $6,428 After 20 years with cumulative inflation of 48%: - Indexed Principal = $1,480,000 - Final coupon = $9,250 for that semi-annual period - Maturity redemption = $1,480,000 **Deflation floor — critical feature:** If CPI falls below original level at maturity, investor receives original face value ($1M), not the deflated amount. This floor is only at maturity — not on coupons. During deflation, coupon payments can still decline (on lower indexed principal). ```mermaid flowchart TD A[Original
Principal] --> B[CPI
Adjustment] B --> C[Indexed
Principal] C --> D[Real Coupon
Payment] C --> E{Maturity?} E -->|Yes| F[Greater of
Indexed or Par] ``` **Settlement mechanics:** Quoted yields are real yields. Secondary market requires accrued interest AND inflation adjustment to get invoice price.

How do TIPS (Treasury Inflation-Protected Securities) mechanically work?

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