Which one of the following best describes a Treasury Inflation-Protected Security (TIPS)?

• A. A U.S. government bond that pays interest only at maturity.
• B. A corporate bond that pays a fixed interest rate regardless of inflation.
• C. A U.S. government bond whose principal increases with inflation and pays interest based on the adjusted principal.
• D. A municipal bond that is exempt from federal income tax.

Answer: (C)

Verified step by step guidance

1. Understand the concept of Treasury Inflation-Protected Securities (TIPS): TIPS are a type of U.S. government bond designed to protect investors from inflation. The principal value of the bond is adjusted based on changes in the Consumer Price Index (CPI), which measures inflation.
2. Recognize how TIPS work: The principal amount of the bond increases with inflation, and the interest payments are calculated based on the adjusted principal. This ensures that both the principal and interest payments keep pace with inflation.
3. Compare TIPS to other types of bonds: Unlike corporate bonds that pay a fixed interest rate or municipal bonds that may be tax-exempt, TIPS specifically address inflation by adjusting the principal value. This makes them unique among bond types.
4. Eliminate incorrect options: A bond that pays interest only at maturity or a corporate bond with a fixed interest rate does not describe TIPS. Similarly, municipal bonds are not related to inflation adjustments.
5. Select the correct description: The correct answer is 'A U.S. government bond whose principal increases with inflation and pays interest based on the adjusted principal,' as this accurately describes the mechanism of TIPS.