How do Treasury Inflation Protected Securities (TIPS) protect investors from inflation?

Treasury Inflation-Protected Securities (TIPS) are specifically designed to provide a safeguard against inflation. They achieve this by adjusting the principal value of the investment based on changes in the Consumer Price Index (CPI), which measures inflation. As inflation rises, the principal amount of TIPS increases, leading to higher interest payments because the interest is calculated based on this adjusted principal. Therefore, when inflation occurs, the returns on TIPS effectively compensate investors by preserving their purchasing power, ensuring that the real value of their investment remains stable over time.

This feature is fundamental to how TIPS function, as they are explicitly structured to counter the erosion of capital that inflation can cause, thus making them a unique investment choice for those concerned about rising prices. The other options, while important aspects of investing in general, do not capture the primary mechanism by which TIPS offer protection against inflation.