coupon rate, pay interest on a semiannual basis, and repay principal at maturity. What is unique is that the principal amount is regularly adjusted to reflect monthly changes in the consumer price index (CPI). If you assume that prices tend to rise, then the principal amount of the bond will rise as the principal is adjusted up. At maturity, the investor will receive the inflation-adjusted amount of principal. TIPS offer an attractive inflation hedge to tax-exempt investors. As of August 2002, the coupon rate is about 3 percent. A return of 3 percent over the rate of inflation may be very attractive to investors such as pension funds that have liabilities influenced by the rate of inflation. Taxes reduce the effectiveness of TIPS as an inflation hedge. Investors are taxed on their interest payments when received, plus are assessed tax on any upward adjustment in the principal amount. The tax on adjustments to the principal amount is levied at the time of the adjustment, even though the investor will not receive the principal until maturity. The adjustments are taxed as ordinary income. Assume prices rise, with the CPI rising 10 percent in a single year. An investor who had purchased a TIPS with a 3 percent coupon rate at par at the beginning of the year would see the notional principal amount of the security adjusted from 100 to 110. The investor would receive about S3.30 in interest. This plus the SlO adjustment in the principal value would create Si 3.30 in taxable income. At 40 percent tax, the liability is S5.32. The investor has a bond with par value of $110, $3.30 in interest, and $5.32 in tax liability for a net of $107.98. This is an after-tax return of about 7.98 percent versus inflation of 10 percent. TIPS are not a good inflation hedge when the portfolio is directly subject to taxation at high rates. TIPS may be an effective hedge if held within a tax-exempt entity such as a foundation. When held within tax-deferred retirement accounts, the effectiveness is greater than in a taxable account but less than in a tax-exempt account. RISK ADJUSTED FOR TAXES AND INFLATION The two previous sections demonstrated that over the past 76 years (1) real aftertax returns were significantly less than nominal returns and (2) cash and bond investments have provided minimal growth in real after-tax wealth. Now, let us turn our attention to risk and see how adjusting for taxes and inflation affect risk calculations. Figure 30.5 shows the risk and return trade-offs of bills, bonds, and stocks based on both nominal and adjusted historic returns. Note that the riskiness of stocks declines when returns are adjusted for taxes. This is because the absolute amount of taxes is high during periods of strong market returns and low or negative during weak markets. The nominal return of Treasury bills is essentially riskless over one-year holding periods. An investor who buys a Treasury bill and holds it until maturity will earn exactly what was expected. However, the real, after-tax return of Treasury bills is not riskless because of the impact of inflation. Readers should not focus too closely on the absolute values plotted in Figure 30.5. They are the result of our arbitrary assumptions regarding tax rates. What is significant is the direction in which the data points shift as we move from nominal results to real, after-tax results.