TIPS are treasury securities and fall into the scope of the SSAP No. 26 Bonds and INT 01-25 Accounting for U.S. Treasury Inflation-Indexed Securities (INT 01-25). INT 01-25 describes TIPS as direct obligations and are backed by the full faith and credit of the United States government. The principal (or par value) of TIPS is protected against inflation as the security is indexed to the Consumer Price Index (CPI) and grows with inflation. The interest is also protected because the interest is paid on the inflation-adjusted principal.
TIPS should be accounted as follows:
- Per INT 01-25, premiums paid or discounts received on the initial purchase of the security should be amortized over the remaining life of the security. Per the annual statement of instructions, this is recorded in column 13 of the Schedule D – Part 1 entitled Current Year’s (Amortization) / Accretion.
- Per INT 01-25, unrealized gain/loss based on the change (the inflation factor times the par value less the prior par value) is recorded as unrealized gain/loss offset to surplus. Per the annual statement of instructions, this is recorded in column 12 of the Schedule D – Part 1 entitled Unrealized Valuation Increase/ (Decrease).
- Inflation adjustment should be recognized as an unrealized gain until it is paid, at which time the unrealized gain held up in surplus should be released and recognized as a realized gain in the statutory income statement.
- Should the inflated principal experience negative CPI, then the worst-case scenario is to lower the value to the original par value when purchased.
- Consideration must also be given to deferred tax and actual tax liabilities as the increase is considered taxable income for the tax books whereas the statutory books holds the increase as unearned income in surplus.
- An entity should consider the methodologies used to capture the specific accounting surrounding TIPS which might need additional attention (sub-ledgers, unearned accounts, and reconciliations) that are not otherwise needed with non-TIPS bonds.
Pros and Cons of Investing in TIPS
- Investors can protect their purchasing power against the risk of inflation in the long run.
- Either the original or adjusted principal will be paid by the U.S. Treasury when TIPS mature, whichever is greater.
- TIPS are not subject to significant default risk or inflation risk.
- While conventional bonds expect future inflation rates built into their yields, TIPS respond to changes in “real” interest rates, i.e., the current interest rates minus inflation rates. Therefore, TIPS will perform better than conventional bonds when actual inflation is higher than expected.
- The market price of TIPS moves substantially with changes in real interest rates, which means the share price of a mutual fund invested in TIPS can vary significantly over the short term.
- For investors seeking long-term capital growth or having a low tolerance towards moderate share price fluctuations, TIPS funds are not an ideal investment.
- When the inflation adjustment to a bond’s value is applied, a taxable income is recognized immediately, even though it is merely “phantom income” as the investors would not realize any gain until the bond is sold or matures.
- If actual inflation is lower than expected, conventional bonds’ performance will likely beat TIPS’ performance.
Overall, TIPS protect investors from inflation. Especially nowadays, the yield on the benchmark 10-year Treasury note is approaching 3%, causing investors to worry about inflation more than ever.