TIPS are designed to protect against purchasing power risk by:

• A. Adjusting the principal semi-annually by the change in CPI.
• B. Providing a fixed inflation rate annuity.
• C. Paying no interest but returning par at maturity.
• D. Being tax-exempt at the federal level.

Answer: (A)

TIPS protect purchasing power by adjusting the principal for inflation. The principal is updated semi-annually based on changes in the Consumer Price Index, so as prices rise, the amount you’re owed increases. Even though the coupon rate is fixed, payments come on the inflated principal, so the real value of both principal and interest tracks inflation. At maturity, you’re guaranteed to receive at least the original par, but if inflation has occurred, you’ll receive the inflation-adjusted principal.

This isn’t a fixed-rate inflation annuity, and you do earn interest (the coupon) on the adjusted principal, not zero interest. Also, TIPS aren’t federal-income-tax-exemption on the interest and adjustments; they’re taxable federally in the year the adjustments occur, even though you don’t receive the cash until maturity.