Both the principal and the interest of TIPS are indexed to inflation. Specifically, the inflation number used is the Consumer Price Index for All Urban Consumers, Not Seasonally Adjusted (CPI-U NSA).

This index is calculated by the Bureau of Labor Statistics (BLS), which is a division of Department of Labor. Inflation can't be measured in real time. BLS announces the CPI number for the previous month between the 15th and 20th of every month. For example, the CPI numbers for September are announced between October 15th and October 20th.

After the BLS announces the CPI number for the previous month, the Treasury Department applies the difference between the latest CPI number and the previous CPI number to the following month.

For example, suppose on October 15 BLS announced that CPI-U NSA increased by 0.2% in September. The Treasury Department will make the principal value of every TIPS bond go up by 0.2% in November. The 0.2% increase is applied evenly throughout the month of November. The value will go up a tiny bit every day in November. By the end of November, the inflation in September is fully reflected in the TIPS principal value. As a result, inflation adjustment in TIPS always has a two-month lag.

Every TIPS bond has a Reference CPI number on the date when it was originally issued. The ratio between the current CPI number and the CPI number on the original issue date is called the index ratio. The index ratio measures how much CPI-U NSA has changed since the bond was issued. The principal value and the interest payments are calculated by the index ratio.

Current Principal Value = $1,000 * index ratio

Inflation adjusted price = quoted price * index ratio

Interest payment = $1,000 * index ratio * interest rate / 2

If there's continued inflation, the principal value of a TIPS bond will continue to go up. The interest payments will also continue to go up. If there's a period of deflation, the principal value will go down in nominal dollars. So will the interest payments.

Par Floor

In the rare event if there's net cumulative deflation from the original issue date to the final maturity date, the deflation adjusted principal value will be lower than the face value. If that happens, the U.S. Treasury will pay the face value.

For example, suppose a bond was issued five years ago with a face value of $1,000. Over the five years, deflation has reduced the index ratio to 0.90. When the bond matures, the deflation adjusted principal value becomes $900. Instead of paying the investor $900, US Treasury pays $1,000.

This feature is called the par floor. It can be a valuable boost to investors if there is prolonged deflation.