High oil prices and low interest rates are among the factors that have conspired to push the inflation rate out of the comfort zone to which Americans have become accustomed.

Inflation ranks among the worst threats that investors must overcome in order to achieve their long-term financial goals. In general, it takes time for an investment to grow, so an investment must outpace inflation in order to show a real return.

Conventional Treasury debt instruments are considered to carry the lowest risk of any debt investment because they are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. But they offer no protection against value lost to inflation.

Fortunately, the U.S. Treasury issues another form of debt that helps protect investors from the effects of inflation: Treasury Inflation-Protected Securities (TIPS).

TIPS are similar to other Treasury bonds, but with an important distinction: The principal increases when the consumer price index (CPI) rises and decreases when the CPI falls. TIPS make interest payments twice a year and return the original or inflation-adjusted principal (whichever is greater) at maturity.

As with other investments, TIPS have advantages and drawbacks. One advantage is that as the principal amount grows, so do the interest payments, meaning that the income generated by TIPS has the potential to rise over time. However, one disadvantage is that you must pay federal income tax on the income plus any increase in principal, even though you won’t receive the accrued principal until the bond matures.

The principal value of Treasury Inflation-Protected Securities fluctuates with changes in market conditions. If not held to maturity, TIPS may be worth more or less than their original value.

This material was written and prepared by Emerald Publications.
© 2008 Emerald Publications