TIPS Bonds are a great way to hedge yourself against inflation, while still making a return on your investment.  Tips, also known as Treasury Inflation Protected Securities, are a type of Treasury bond that provides protection against inflation.  Many investors and businesses worry about inflation because it means they have less purchasing power with the money they have.  The federal government created in 1997 an investment instrument that guarantee investors a specified interest rate plus additional payment if there is inflation during the time an investor owns the investment.  They called these investments “TIPS,” or Treasury Inflation Protect Securities.
 

TIPS Bonds set their yield (interest rate) when they are initially sold during a U.S. Treasury Auction, so a bond investor is guaranteed the specified interest rate.  The principal, which is the amount of money invested into the bond, will adjust with the rate of inflation.  As the rate of inflation increases, so does the investor’s TIPS principal. 

Here is a real-world example:  You own an ordinary Treasury Bond with a 6.2% yield and a TIPS Bond with a 4.2% yield.  The CPI (Consumer Price Index) increased 3%, then the real yield of an ordinary Treasury bond, after inflation, sinks to 3.3%.  TIPS though will actual hold their yield steady at 4.2%.

This example shows that you are guaranteed the initial 4.2% yield no matter how high inflation increases, which is a win-win for many investors.

TIPS Bonds investors will receive semi-annual interest payments and will fluctuate based on the CPI.  The CPI, also known as the Consumer Price Index, measures the average cost of goods and services purchased by households.  An increase in the CPI means that costs for goods and services have increased, which is a sign for inflation.  The underlying value of the principal grows at the same rate of rising prices. When the principal grows, interest payments grow also since interest payments are a fixed percentage of principal. At maturity, if inflation has occurred and increased the value of the underlying security, the US Treasury will pay the owner the higher inflation-adjusted principal.