Treasury Inflation-Protected Securities: What are TIPS?

TIPS — short for Treasury Inflation-Protected Securities — are a kind of U.S. government bond that can help safeguard your wealth from inflation. TIPS are indexed to inflation, so as prices rise, your investment principal increases, protecting any investment you’ve made in the bonds. With inflation still well above the Federal Reserve’s long-term target of 2 percent, TIPS can help you maintain your purchasing power.

Contents

What are TIPS and how do they work?An example of how a TIPS bond works How to invest in TIPS Advantages and disadvantages of TIPS Bottom line

Here’s what you need to know about TIPS and how they work to protect your money.

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What are TIPS and how do they work?

TIPS are a government bond backed by the “full faith and credit” of the U.S. government, making them as risk-free as any other traditional federal bond. Where they differ from other bonds is in how they are structured to respond to the rate of inflation or deflation.

TIPS respond to changes in the consumer price index (CPI), a measure of inflation for consumers, as follows:

If the index rises, signaling inflation, the bond’s principal increases an equivalent amount.
If the index falls, signaling deflation, the bond’s principal decreases an equivalent amount.

How does the inflation adjustment work? Unlike other typical inflation-linked bonds, TIPS pay interest at a fixed rate. Instead, the principal on a TIPS bond adjusts to the price index every six months. TIPS pay interest semiannually, and are issued in terms of five years, 10 years and 30 years.

So the amount that you receive in interest and the return of capital from the bond at maturity is affected by inflation and the fixed interest rate you receive.

It’s worth noting, however, that the situation works in reverse with deflation, meaning that your principal during the term of the bond can decline. However, at the bond’s maturity, the U.S. Treasury promises to return the adjusted principal or the original principal, whichever is greater.

That promise means that you won’t lose principal, but it doesn’t mean that you’ll like the returns.

Like other government bonds, TIPS can be sold in the secondary market, but there’s no guarantee that you’ll get what you paid for the bond. The U.S. Treasury’s guarantee that you receive your full principal applies only to bonds that reach maturity.

So TIPS are structured differently from the highly popular Series I bond, which adjusts the interest rate it pays in response to inflation, rather than the principal.

An example of how a TIPS bond works

For example, imagine you invested $10,000 in TIPS, paying a 1 percent yield and inflation rises to 5 percent, as measured by the CPI.

Initially, you’d earn $100 in interest annually on your $10,000 in principal.
After the inflation adjustment, your principal would rise to $10,500 and you’d still earn that 1 percent fixed rate, and the TIPS bond would now pay $105 annually, or the principal times the fixed interest rate.

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How to invest in TIPS

Investors looking to purchase TIPS can do so in a few ways, though one is much easier than the others:

You can buy TIPS on TreasuryDirect, the source for investors to buy straight from the U.S. Treasury in an auction. The interest rate is determined by the auction. If you buy from the Treasury, you can purchase TIPS in increments of $100, with a $100 minimum purchase. If you purchase through TreasuryDirect, you must hold the bonds for 45 days. Auctions for various maturities are held only in specific months.
You can also buy individual TIPS bonds through a bank or brokerage.
An easier solution for most investors is to buy an exchange-traded fund or mutual fund that invests in TIPS. These funds are highly liquid and easy to trade on an exchange when you’re ready to buy or sell.

Investors thinking about buying TIPS should understand how they fit in with the rest of their portfolio strategy and whether they make sense, given the inflation outlook. Slowing inflation will likely be better for typical fixed-rate bonds than for inflation-protected bonds.

Advantages and disadvantages of TIPS

While TIPS solve for the problem of inflation, they have other downsides that may be less obvious.

Inflation protection. The obvious reason to invest in TIPS is for the inflation protection, since that’s what they were created for. The principal will adjust in response to changes in the Consumer Price Index.
Tradable on an exchange. You’ll also be able to sell TIPS in the secondary market, if you need liquidity, though there is no guarantee that you’ll get what you paid.
Low default risk. Backed by the U.S. government, TIPS are as safe as any other federal bond.
Exempt from state and local taxes. Any income from TIPS is exempt from state and local taxes, allowing you to skip those additional assessments.
Deflation protection. TIPS also offer a form of deflation protection, ensuring that at maturity you’ll never receive less than the face value of the TIPS bonds that you’ve purchased.

Principal could decline in the interim. If deflation occurs, TIPS could decline in value, meaning that you might not be able to sell them for what you paid.
Lower rates in low-inflation climates. TIPS generally will pay less than comparable Treasurys in low-inflation environments. The reason: The market factors the cost and potential benefit of inflation into the fixed interest rate it’s willing to accept.
CPI may understate actual inflation. TIPS are repriced based on inflation as defined by the CPI, and the CPI may not accurately reflect the inflation experienced by consumers. The result is that you may still lose actual purchasing power.
Interest and principal adjustments are taxable in the year of receipt. You’ll pay tax at ordinary income rates (which are generally more than rates on dividend income) not only on interest income but also on the principal adjustment. Having to pay taxes on the principal adjustment may be frustrating since you may not have actually realized that gain, and it may still be sitting tied up in the bond. So you’ll have to front the money for the taxes even though you haven’t been paid the income yet.

Bottom line

TIPS offer a solution for investors who are worried about the specter of inflation while investing in bonds, which otherwise may not yield enough to keep up with rising prices. But they’re not without some costs for the protection, namely subpar yields during low-inflation environments.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.