TIPS are Treasury Inflation Protected Securities. They are a special kind of bond issued by the United States Treasury. They are special because their principal and interest are indexed to the Consumer Price Index, which is a measure of inflation.
A regular, or in bond-speak, “nominal” bond is an IOU. The government borrows $100 from you. They promise to pay you back $100 some time in the future. While they have your money, they pay you interest every six months. The interest payments are fixed. If you have a 4% bond, for every $1,000 you lend to the government, you receive $20 interest every six months ($1,000 * 4% / 2 = $20).
TIPS work the same way, except everything is indexed to the CPI. The government borrows $100 from you today. When they pay you back, if the CPI doubled, they pay you back $200, although that $200 is really worth only $100 in today’s dollars because of inflation. The interest payments are also indexed to the CPI. If you receive $20 interest in year 1 and the CPI increased by 50% in year 15, you will receive $30 interest in year 15. After adjusting for inflation, that $30 in year 15 is worth the same as $20 in year 1. Because the principal payback and the interest payments are indexed to the CPI, TIPS are said to have inflation protection.
Like regular Treasury bonds, TIPS are also guaranteed by the full faith and credit of the United States Treasury. The interest you receive from TIPS is taxable under federal income tax, but exempt from state and local income tax.
Of course because some inflation is expected, the inflation protection in TIPS does not come for free. The interest rate on TIPS is typically lower than that on regular bond of the same term. For example when the interest rate on a 10-year TIPS was 0.76%, the interest rate on a 10-year Treasury bond was 2.88%. If the Consumer Price Index increases by 2.12% a year in the following ten years, an investor would receive the same return from either the 10-year TIPS or the 10-year nominal Treasury bond.