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TIP: Return of Your Money
Research for Online Investors

This article appeared in MarketToday on 7/06/10

by John Dalt

After the market volatility of the last two months you may have some cash sitting on the sidelines. A safe place to park money looks better and better to many investors as evidenced by the recent dip below 4% on 10-year Treasuries. Interest rates can only drop this low when fear helps investors remember the most important equation is “Return of my money…then return on my money.”

One place you might look is “TIPS” or Treasury Inflation Protected Securities.  TIPS are sold in $100 increments, and can be purchased from your local bank, brokers, or if you prefer directly from the U.S. Treasury.  TIPS are sold with maturities of five, ten, and 30-years.  A bank or broker will charge a commission on the sale.  There is no commission or fee if TIPS are purchased direct from the Treasury.

TIPS face values are adjusted based on inflation as measured by the Core Consumer Price Index (CCPI), and pay interest every six months. If you buy $1,000 dollars face value in TIPS that pay 3% interest, on the six month anniversary the face value will be adjusted up or down (with inflation) and then pay the 3% interest on that adjusted amount.

If there is no inflation during the last six months, the face value would remain the same and the interest payment would be $15 dollars.  If the CCPI measured 10% deflation, the face value would be adjusted to $900 and the interest would be calculated on this amount, paying $13.50 ($900 x 0.03 = $27 / 2 = $13.50).  If inflation were 10% the face value will be adjusted to $1100 and the interest would be calculated on this amount, paying $16.50 ($1100 x 0.03 = $33.00 / 2 = $16.50).

The beauty of TIPS?  You won’t lose money if you hold them to maturity.  The government will pay you the higher face value from inflation, or in the case of deflation they will still pay the ORIGINAL face value.  This means you may receive less interest because of deflation but will always receive at least your original capital invested back.

The Fed has been fighting deflation, trying to kick start the economy with low interest rates and purchases of securities. As all that “new” money makes it into the system and banks start lending it, there is little doubt we will face inflation. Inflation will probably accelerate before the Fed can withdraw “excess liquidity” from the market. With high unemployment there is pressure to let the economy heat up, rather than withdraw any stimulus.

One tax point to be aware of is that the interest payments and any increase in face value are taxable in the year it occurs.  TIPS are exempt from state and local taxes but subject to Federal taxes.  TIPS can be held in tax exempt retirement accounts, as well as by corporations, trusts, estates, and partnerships.

Five-year TIPS are auctioned in April and October, Ten-year TIPS are available in January, March, July, September and November.  You can buy through a broker or bank out of their inventory at other times.

For more information, you can read more at the TreasuryDirect website on TIPS: Rates & Terms.

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Special Note added after article publication:
The CCPI bears a quick explanation.  Core CPI excludes energy and food costs so it is generally less than the widely quoted CPI numbers.  This can lead to confusion and in the present Fed induced commodity inflation may disqualify TIPS as a good choice for inflation protection.

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You can also invest in a mixed bag of TIPS instruments through the etf TIP. TIP charges a 0.20% annual administration fee, which will lower your return if you are holding for an extended period of time.  TIP pays interest monthly and currently yields 3.84%.  The Ex-dividend date is generally  the first of the month, with interest payed a week later.  This can be an excellent place to "park" money while we are riding out the turbulence in the market.  The iShares Page on TIP Bond Fund etf provides more information.

Please be aware that the TIP etf stock price fluctuates, so you are exposed to market risk as it prices according to buyer and seller interest.  So you are not guaranteed your original investment back when you decide to sell.  Also, some of the treasury auctions are "re-openings" of previously priced securities.  You are not guaranteed the current purchase price, but the original face value.

The information presented in this newsletter is based on generally available news releases, corporate filings, current events, interviews and the editor’s opinions. It may contain errors and you should not make investment decisions based solely on what you believe you have read here. Do your own research, it is your money. If you lose it, it is your responsibility, not ours or your grandmothers! The editor may or may not have a position in any securities discussed. The editor may have held a position in a security earlier, or in the future.

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