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Difficulty: MediumGovernment, Municipal, and Corporate Bonds

An investor purchases a newly issued Treasury Inflation-Protected Security (TIPS) with a principal value of $1,000 and a 3% coupon rate. During a year in which the Consumer Price Index (CPI) increases by 4%, which of the following statements correctly describes the impact of this inflation adjustment on the bond's principal value and its federal income tax treatment for that year?

  1. The principal value increases to 1,040,andthe1,040, and the 40 principal increase is subject to federal income tax in the year it occurs, even though the investor does not receive the principal payout until maturity.Answer
  2. B
    The principal value increases to 1,040,butthe1,040, but the 40 inflation gain is tax-deferred until the bond is sold or reaches maturity.
  3. C
    The principal value remains fixed at $1,000, while the coupon rate increases from 3% to 7% to account for the 4% inflation rate.
  4. D
    The principal value is reduced to $960 to offset the purchasing power loss, resulting in lower semi-annual interest payments.

Answer

The principal value increases to 1,040,andthe1,040, and the 40 principal increase is subject to federal income tax in the year it occurs, even though the investor does not receive the principal payout until maturity.
Treasury Inflation-Protected Securities (TIPS) are designed to protect investors from purchasing power risk by adjusting their principal value semi-annually based on the Consumer Price Index (CPI). When inflation rises by 4%, the principal value of a 1,000bondincreasesto1,000 bond increases to 1,040. The IRS requires the investor to report and pay federal income tax on this $40 annual principal increase in the year it accrues, a concept known as phantom income.

Step-by-Step Solution

1
Calculate the inflation adjustment to the principal value.
Inflation of 4%4\% on a $1,000\$1,000 principal value increases the principal by $1,000×0.04=$40\$1,000 \times 0.04 = \$40, bringing the new principal value to $1,040\$1,040.
TIPS principal values adjust directly in proportion to changes in the Consumer Price Index (CPI).
2
Determine the federal tax obligation regarding the principal adjustment.
The $40\$40 increase in principal value is classified as taxable interest income at the federal level in the year it is earned.
Under federal tax rules, annual inflation adjustments to TIPS principal are considered 'phantom income' and must be reported annually, despite not being disbursed as cash until redemption.

Key Concept

Mechanism and annual taxation of Treasury Inflation-Protected Securities (TIPS) principal adjustments
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Topics

Government, Municipal, and Corporate Bonds

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