Deflation and Treasury Inflation-Protected Securities ("TIPS")

Unlike the inflation-indexed securities of some other countries, U.S. Treasury TIPS have a minimum guarantee. In the event of deflation over the life of a particular inflation-indexed security, an additional amount will be paid to the holder of the principal at maturity which will be equal to the difference between the original par value of the bond and the inflation-adjusted principal. (In this case, inflation is negative.) Note that this does not affect the semiannual coupon payments, which are always based on the inflation-adjusted principal value.

What this means is that the real yield on a TIPS held from issuance to maturity will be higher if there is deflation than if there is inflation over the life of the security. However, this possibility is reduced from the point of view of the investor for acquisitions of outstanding TIPS and those bought at reopenings, if the principal has had a positive inflation-adjustment. In other words, if there is the prospect of deflation going forward, the minimum guarantee is more valuable for newly issued TIPS which have not had any positive inflation-adjustment to the principal.

The reason TIPS have this feature is tax considerations. When I was working on the design of TIPS, I was informed by Treasury tax staff that they needed to qualify as a debt instrument. This is a bit of a murky area, but in order to satisfy this tax concern, I was told that the sum of all the payments on the bonds (interest and principal) had to equal the original par amount. Accordingly, the original proposal for inflation-indexed securities published in the Federal Register (May 20, 1996) included the following provision: "If the sum of all the interest payments and the inflation-adjusted principal is less than the par value of the security at time of issuance, the Treasury will pay an additional sum at maturity equal to the difference." This was the minimum necessary to satisfy the tax concern.

During the comment period, some market participants argued that the minimum guarantee should be made simpler and not include the interest payments. That is what was eventually decided that Treasury would do. At the time, it was thought deflation would never happen, and perhaps it is still not likely over a five-year period (the shortest maturity of TIPS). But it is not impossible.

The tax considerations in the event of deflation are complicated, and there may be questions raised by taxpayers if it occurs. In general, during a year in which there is deflation, the taxpayer holding a TIPS can use the decline in the inflation-adjusted value of the principal to offset coupon payments received that year on the security. If there is still an excess after that has been done, the taxpayer can take an ordinary deduction to the extent interest on the security has been included in the taxpayer's income for prior years.  If there is still an excess, it is carried forward. The minimum guarantee payment is included in income as interest in the year it is received. Tax considerations get more complicated if the security is sold. For those interested in tax issues (or interested to check if my general description is right), one place to start researching this is IRS regulation 1.1275-7.  IRS Publication 1212 ("Guide to Original Issue Discount (OID) Instruments") also provides some information on the taxation of TIPS. (It should go without saying that anyone faced with a particular tax issue in regard to TIPS should not rely on what I have written here.)

Note:  The link to the Federal Register may not work.  If it doesn't and you are interested in the document, go to this web page, remove the check mark for 2010, and search for "inflation-indexed" on May 20, 1996.