What Are Treasury Inflation-Protected Securities (TIPS)?
Treasury Inflation-Protected Securities (TIPS) are a type of Treasury security issued by the U.S. government. TIPS are indexed to inflation to protect investors from a decline in the purchasing power of their money.
As inflation rises, rather than their yield increasing, TIPS instead adjust in price (principal amount) to maintain their real value. The interest rate on a TIPS investment is fixed at the time of issuance, but the interest payments keep up with inflation because they vary with the adjusted principal amount.
- Treasury Inflation-Protected Securities (TIPS) are a type of Treasury bond that is indexed to an inflationary gauge to protect investors from a decline in the purchasing power of their money.
- The principal value of TIPS rises as inflation rises, while the interest payment varies with the adjusted principal value of the bond.
- The principal amount is protected since investors will never receive less than the originally invested principal.
Treasury Inflation-Protected Securities (TIPS)
Understanding Treasury Inflation-Protected Securities (TIPS)
The principal value of TIPS rises as inflation rises. Inflation is the pace at which prices increase throughout the U.S. economy, as measured by the Consumer Price Index (CPI). Inflation becomes an issue when there isn’t a commensurate rise in real wage growth to offset the negative effects of rising prices.
TIPS are a popular asset for protecting portfolios from inflation and profiting from it because they pay interest every six months based on a fixed rate determined at the bond’s auction. However, the interest payment amounts can vary since the rate is applied to the adjusted principal or value of the bond. If the principal amount is adjusted higher over time due to rising prices, then the interest rate will be multiplied by the increased principal amount. As a result, investors receive higher interest or coupon payments as inflation rises. Conversely, investors will receive lower interest payments if deflation occurs.
TIPS are issued with maturities of five, 10, and 30 years and are considered a low-risk investment because the U.S. government backs them. At maturity, TIPS return the adjusted principal or the original principal, whichever is greater.
TIPS can be purchased directly from the government through the TreasuryDirect system, in $100 increments with a minimum investment of $100, and are available with the aforementioned maturities.
Some investors prefer to get TIPS through a TIPS mutual fund or exchange-traded fund (ETF). However, purchasing TIPS directly allows investors to avoid the management fees associated with mutual funds.
TIPS’ Price Relationship to Inflation
TIPS are important since they help combat the inflation risk that erodes the yield on fixed-rate bonds. Inflation risk is an issue because the interest rate paid on most bonds is fixed for the life of the bond. As a result, the bond’s interest payments might not keep up with inflation. For example, if prices rise by 3% and an investor’s bond pays 2%, then the investor has a net loss in real terms.
TIPS are designed to protect investors from the adverse effects of rising prices over the life of the bond. The par value—principal—increases with inflation and decreases with deflation, as measured by the CPI. As mentioned earlier, when TIPS mature, bondholders are paid the inflation-adjusted principal or original principal, whichever is greater.
Suppose an investor owns $1,000 in TIPS at the end of the year, with a coupon rate of 1%. If there is no inflation as measured by the CPI, then the investor will receive $10 in coupon payments for that year. If inflation rises by 2%, however, then the $1,000 principal will be adjusted upward by 2% to $1,020. The coupon rate will remain the same at 1%, but it will be multiplied by the adjusted principal amount of $1,020 to arrive at an interest payment of $10.20 for the year.
Conversely, if inflation were negative—known as deflation—with prices falling 5%, then the principal would be adjusted downward to $950. The resulting interest payment would be $9.50 over the year. However, at maturity, the investor would receive no less than the principal amount invested of $1,000 or an adjusted higher principal, if applicable.
The interest payments during the life of the bond are subject to being calculated based on a lower principal amount in the event of deflation, but the investor is never at risk of losing the original principal if held to maturity. If investors sell TIPS before maturity in the secondary market, they might receive less than the initial principal.
TIPS don’t work as a short-term hedge against spikes in inflation. Their real function is to protect investors against rising living costs over the long term.
How to Buy TIPS
As with other Treasury securities, investors can buy TIPS directly from the U.S. government at the Treasury website TreasuryDirect.gov. This entails a somewhat complicated login process with several security layers.
Advantages and Disadvantages of TIPS
While TIPS are an attractive prospect for investors who expect high levels of inflation, they are at a disadvantage to other types of debt during periods of ordinary inflation. Below are some other considerations to keep in mind:
- Lower yield: TIPS usually pay lower interest rates than other government or corporate securities, so they are not necessarily optimal for income investors. Their advantage is mainly inflation protection, but if inflation is minimal or nonexistent, then their utility decreases.
- Tax considerations: Like other Treasury bonds, the interest and inflation adjustments on TIPS are exempt from state and local income taxes. However, the inflation adjustment is considered taxable income by the Internal Revenue Service (IRS), even though investors don’t see that money until they sell the bond or it reaches maturity. Some investors hold TIPS in tax-deferred retirement accounts to avoid tax complications. However, it may be worth contacting a tax professional to discuss any potential tax ramifications of investing in TIPS.
The principal increases with inflation, meaning that at maturity, bondholders are paid the inflation-adjusted principal
Investors will never be paid less than their original principal when TIPS mature
Interest payments increase as inflation increases, since the rate is calculated based on the adjusted principal balance
The interest rate offered is usually lower than most fixed-income bonds that do not have an inflation adjustment
Investors might be subject to higher taxes on increased coupon payments
If inflation does not materialize while TIPS are held, then the utility of holding TIPS decreases
Example of TIPS
Below is a comparison of the 10-year TIPS to the 10-year Treasury note, both issued and auctioned by the U.S. Treasury Department. Treasury notes (T-notes) are intermediate-term bonds maturing in two, three, five, seven, or 10 years. They provide semiannual interest payments at fixed coupon rates.
As a historical example, on March 29, 2019, the 10-year TIPS was auctioned with an interest rate of 0.875%. On the other hand, the 10-year Treasury note was auctioned on March 15, 2019, with an interest rate of 2.625% per year.
We can see that the 10-year note pays more interest (meaning that investors will receive higher coupon payments from the 10-year note compared to the TIPS investment). However, if inflation rises, then the principal on the TIPS will increase, allowing for the coupon payments to rise, while the 10-year note is fixed for the life of the bond. Although TIPS protect against inflation, the offset is typically a lower yield than bonds with similar maturities.
How Did TIPS Perform in 2022?
In 2022, inflation in the United States hit highs not seen in four decades, leading many investors to flock to TIPS for protection. However, that insurance policy didn’t really go according to plan. These inflation-protecting securities fell an average of 14.2% during the course of the year, performing not much better than regular Treasuries and major equity markets.
This serves as a reminder of how TIPS work and how they are often misunderstood. When inflation soared in 2022, the Federal Reserve—as it normally does when the cost of living rockets—hiked interest rates. And steep increases in the cost of borrowing caused TIPS, like the rest of the bond market, to plummet in value, despite the extra payouts tied to inflation.
What 2022 taught many investors is that TIPS carry the same underlying interest rate risk exposure as other bonds and, therefore, are not the pure-play inflation hedge that some people may have thought they were. Many were fooled into thinking that TIPS returns are perfectly correlated to changes in inflation. Hopefully, they have learned their lesson.
TIPS are designed to protect investors against inflation over the long term rather than act as a short-term hedge against soaring prices.
How Can I Buy Treasury Inflation-Protected Securities (TIPS)?
You can buy TIPS directly from the U.S. Treasury’s TreasuryDirect website, with a minimum purchase of $100. You can also typically buy them through your broker. There are also several mutual funds and exchange-traded funds (ETFs) that invest in TIPS and other inflation-linked securities that you can buy and sell like ordinary shares of stock.
Can I Buy TIPS for My Individual Retirement Account (IRA)?
Yes. You can include TIPS and funds that hold TIPS in an individual retirement account (IRA); however, you cannot use the TreasuryDirect service to buy them directly in an IRA. Instead, you would need to rely on the broker holding your retirement account.
What Yields Do TIPS Have?
The yields on TIPS are often negative. This is because after taking into account the effects of inflation, the real yield is negative. For instance, if standard two-year Treasuries yield 1% but inflation is 2%, then the real yield is -1%.
TIPS are meant to keep up with inflation, not beat inflation. Therefore, you can have a nominal yield on TIPS that is positive but a real yield that is effectively zero. Note that while the yield on TIPS may be negative, their principal value will increase with inflation, which can generate capital gains.
Why Does the Treasury Issue TIPS?
TIPS first appeared in 1997. The official reason for their appearance is that there was strong demand from the investing public for inflation-linked government securities. However, some economists have been puzzled by the government’s continued issuance of TIPS since they amount to a more expensive way to borrow than traditional Treasuries.
What Maturities Do TIPS Come in?
The original TIPS were set at 20-year maturities. In 2009, 20-year TIPS were discontinued in favor of 30-year TIPS. The U.S. Treasury currently issues five-, 10-, and 30-year TIPS.
The Bottom Line
TIPS are among the many types of debt securities offered by the U.S. Treasury Department. You can think of them as Treasuries with a twist—their principal value is tied to inflation to protect investors when the cost of living rises. However, they are often misunderstood.
It’s important to know that inflation protection comes at a cost, as most of these securities carry lower interest rates than other similar government bonds. Also, bear in mind that at the time of maturity, bondholders are paid the inflation-adjusted principal or original principal, whichever is greater. In other words, there’s protection in place for instances when there’s lots of deflation.
Another common misconception is that TIPS are guaranteed to do well when inflation is rising and function as a great short-term hedge when the cost of living suddenly spikes. As 2022 taught us, TIPS are bonds at the end of the day, and bond markets react badly to rising interest rates.