The TIPS Deflation Floor
US inflation-protected Treasury bonds guarantee repayment of at least the original face value at maturity, even if cumulative inflation over the bond's life turns out to be negative.
Prerequisites: Inflation-Linked Bonds and TIPS
A Treasury Inflation-Protected Security (TIPS) adjusts its principal up with the Consumer Price Index over its life, so a holder is repaid in real, inflation-adjusted terms rather than fixed nominal dollars. The natural worry this raises is: what happens if prices actually fall, and the inflation-adjusted principal would come out below the original $1,000 face value?
The US Treasury built in a deflation floor: at maturity, a TIPS investor is guaranteed to receive at least the original par (face) value, even if the inflation-adjusted principal has fallen below it because of cumulative deflation.
TIPS adjust principal down with deflation just as they adjust it up with inflation, but a deflation floor guarantees repayment of no less than the original face value at maturity — turning that specific downside risk into a free embedded option for the investor.
Worked example
A TIPS is issued at $1,000 face value. Over its life, cumulative deflation shrinks the inflation-adjusted principal to $950. Without a floor, the investor would receive only $950 at maturity. Because of the deflation floor, the investor still receives the full $1,000 — the floor effectively pays out an extra $50 that the pure inflation-adjustment formula would not have provided.
The floor only applies to principal repaid at maturity, not to the semiannual coupon payments, which are still computed off the (possibly lower) deflation-adjusted principal along the way.
Related concepts
Practice in interviews
Further reading
- US Treasury, 'TIPS: Description and Mechanics'