How do TIPS actually protect against inflation? I'm confused about whether the coupon or the principal adjusts.
Studying CFA Level I fixed income and the TIPS section seems straightforward until I try to work through the numbers. I know TIPS protect against inflation, but does the coupon rate change or does the principal adjust? And what happens in a deflationary period?
TIPS (Treasury Inflation-Protected Securities) are one of the most frequently tested fixed income topics in CFA Level I, and the mechanics trip up a lot of candidates. Let me clear up the confusion.
The Core Mechanism: Principal Adjusts, Coupon Rate Stays Fixed
The coupon rate on a TIPS is fixed at issuance and never changes. What adjusts is the principal value based on the Consumer Price Index (CPI). The coupon payment equals the fixed rate applied to the inflation-adjusted principal.
How It Works Step by Step
Worked Example: 2-Year TIPS, 1.0% Coupon, Semi-Annual (fictional scenario)
| Period | CPI Index | Index Ratio | Adjusted Principal | Coupon (0.5%) | Total Cash |
|---|---|---|---|---|---|
| Issue | 305.0 | 1.0000 | $1,000.00 | -- | -- |
| 6 months | 309.5 | 1.01475 | $1,014.75 | $5.07 | $5.07 |
| 12 months | 315.2 | 1.03344 | $1,033.44 | $5.17 | $5.17 |
| 18 months | 318.0 | 1.04262 | $1,042.62 | $5.21 | $5.21 |
| 24 months | 322.7 | 1.05803 | $1,058.03 | $5.29 | $1,063.32 |
Index ratio = Current CPI / Reference CPI at issuance
Notice how the coupon payment grows over time even though the coupon rate is constant at 1.0%. This is because the principal base keeps increasing with inflation.
Deflation Protection
At maturity, TIPS pay the greater of the inflation-adjusted principal or the original par value ($1,000). So if cumulative deflation pushed the adjusted principal down to $970, you'd still receive $1,000. However, during the life of the bond, coupon payments are based on the actual adjusted principal -- so in a deflationary period, your coupons could temporarily decrease.
TIPS vs. Nominal Treasury: Breakeven Inflation
Breakeven inflation = Nominal Treasury yield - TIPS real yield
If a 10-year nominal Treasury yields 4.2% and a 10-year TIPS yields 1.8%, the breakeven inflation rate is 2.4%. If realized inflation exceeds 2.4%, the TIPS investor wins; if inflation is below 2.4%, the nominal Treasury investor wins.
Tax Complication: The increase in principal is taxable as income in the year it occurs, even though you don't receive the principal until maturity. This creates 'phantom income' -- you owe taxes on money you haven't received yet. This makes TIPS most tax-efficient in tax-deferred accounts.
Exam Tip: CFA Level I questions typically give you the CPI values and ask you to compute the adjusted principal and coupon payment. Always multiply the coupon rate by the adjusted principal, not the original par.
Learn more about inflation-linked bonds in our fixed income materials.
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