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Question

Difficulty: MediumGovernment, Municipal, and Corporate Bonds

An investor is evaluating U.S. Treasury Inflation-Protected Securities (TIPS) for inclusion in a conservative portfolio. Which of the following statements accurately describes the mechanism by which TIPS adjust for inflation?

  1. The principal value increases with inflation based on the Consumer Price Index, and the fixed coupon rate is applied to the adjusted principal.Answer
  2. B
    The coupon rate fluctuates based on the Consumer Price Index while the principal value remains fixed at par value.
  3. C
    The market price of the bond rises whenever prevailing market interest rates increase, guaranteeing positive capital gains during rate hikes.
  4. D
    The inflation-adjusted principal growth is completely exempt from federal income taxation until the bond reaches final maturity.

Answer

The principal value of TIPS increases with inflation based on the Consumer Price Index (CPI), and the fixed coupon rate is applied to this adjusted principal value.
Treasury Inflation-Protected Securities (TIPS) protect investors against purchasing power risk by adjusting their principal value semiannually based on changes in the Consumer Price Index (CPI). Because the coupon rate remains fixed, applying that fixed percentage to a growing principal results in larger dollar interest payments as inflation rises.

Step-by-Step Solution

1
Identify the structural mechanism of U.S. Treasury Inflation-Protected Securities (TIPS).
TIPS feature a fixed coupon rate paired with a principal value that adjusts semiannually based on changes in the Consumer Price Index (CPI).
Understanding how TIPS adjust principal rather than interest rates is essential for evaluating how purchasing power protection is achieved.
2
Determine how inflation adjustments impact semi-annual coupon payments.
The fixed percentage coupon rate is multiplied by the inflation-adjusted principal amount, resulting in higher dollar interest payments during inflationary periods.
Dollar income increases over time because the fixed coupon rate applies to a growing principal balance.

Key Concept

TIPS Principal Adjustment and Inflation Protection
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Topics

Government, Municipal, and Corporate Bonds

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