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?
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.
This quiz is intended for informational and illustrative purposes only. This material is not intended to be relied on as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you. The information and opinions contained in this material are derived from sources deemed reliable, are not all-inclusive and are not guaranteed as to accuracy.
The information presented by WrapManager, Inc. is general information only and does not represent tax or legal advice, either expressed or implied. You are encouraged to seek professional tax advice for income tax questions and assistance. WrapManager, Inc. does not advise on any income tax requirements or issues.