Protecting Principal Against Inflation via TIPS
Your friend Karen is concerned about inflation increasing so she purchases $1,000 of a Treasury Inflation Protected Securities (TIPS) bond with a semi-annual coupon payment of 2%. TIPS are unique in that the principal amount ($1,000 in this case) will increase with inflation. For example, if there was 3% inflation over the first six months of the bond, the principal amount would adjust to $1,030 ($1,000 x 1.03 = $1,030).
Karen isn't quite certain how the semi-annual coupon payments on TIPS work, so she asks for your help. She thinks inflation will be 2% over the first 6 months of owning the bond and 3.25% for the six months following. What is the total amount of coupon payments would she get from her TIPS bond over the first year under this scenario?
- $20
- $20.53
- $20.73
- $20.80
(Answer below...)
What are Treasury Inflation Protected Securities (TIPS)?
According to Investopedia treasury inflation protected securities (TIPS) refer to a treasury security that is indexed to inflation to protect investors from the negative effects of inflation. TIPS are backed by the U.S. government and their par value rises with inflation - as measured by the Consumer Price Index - while the interest rate remains fixed.
Solution: Answer 3 is the correct solution!
The principal amount gets adjusted for inflation every 6 months. The coupon payment will be the coupon rate times the adjusted principal and that number is divided by 2 since coupon payments are made semi-annually.
The first coupon payment will be $1,000 x 1.02 = $1,020 x 0.02 = $20.4 / 2 = $10.2
The second coupon payment will be $1,020 x 1.0325 = $1,053.15 x 0.02 = $21.06 / 2 = $10.53
The total amount of coupon payments received in the first year under this scenario will be: $10.2 + $10.53 = $20.73
Karen should consider working with a financial advisor who can help her navigate scenarios such as this.
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