This means that, as inflation increases, the value of TIPS bonds increase even though the interest rate doesn't. Why? TIPS holders get a larger cash payment because the fixed interest rate is applied to a larger principal.
The opposite is true in times of deflation. If prices go down overall, as measured by the CPI, the value of TIPS will also decline because now the fixed interest rate is being applied to a lower principal.
The fixed interest rate is determined by the initial TIPS auction. TIPS are issued in terms of 5, 10, and 30 years. You can hold TIPS until they mature, or auction them off yourself on the secondary market.
Here's a nice benefit of TIPS. When they mature, you receive either the adjusted principal, or the original principal, whichever is higher. This provision protects you against deflation.
As you would expect, TIPS do well during inflation, or even if inflation is expected. People will pay a lot more for the safety of TIPS if they are afraid of inflation. For this reason, TIPS also do well when the value of the dollar is declining. That's because a declining dollar usually leads to inflation, at least for imported goods.
TIPS do worse during times of deflation. They aren't really a great investment during a stable economy. That's because,over the long haul, they do not return as much as a well-diversified portfolio that includes stocks. Of course, they are guaranteed by the government, so you do get less risk - but you also get a lower return.
You can buy TIPS directly from the Treasury if you go open a Treasury Direct Account.
