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Treasury Inflation Protected Securities, commonly known as TIPS, are bonds issued by the U.S. government that offer protection against inflation, in addition to modest interest payments.
“For investors who prioritize preserving the purchasing power of their cash, TIPS can help mitigate the impact of unexpectedly high inflation,” says Wes Crill, head of investment strategists at Dimensional Fund Advisors in Austin, Texas.
What Are TIPS?
TIPS are type of U.S. Treasury debt that pay a semi-annual fixed interest rate, with maturities that range from five to 30 years. Besides being ultra-low-risk government securities, the appeal of TIPS is that they offer an attractive hedge against inflation.
Additionally, they offer tax benefits as the inflation adjustments in the principal value are tax-exempt at the state and local levels, though interest payments are subject to federal income tax. In the case of deflation, the Treasury guarantees that investors will receive at least the original face value (adjusted for inflation) when the bond matures.
While TIPS offer protection against inflation, they also carry interest rate risk, as their market value may fluctuate with changing interest rates.
How Do TIPS Work?
TIPS are fixed income securities that work similarly to other treasury bonds. When you buy TIPS, you get regular interest payments on the par value of the securities, and you get your principal back when the TIPS reach maturity.
Here’s how TIPS protect your investment from inflation: Each year, the U.S. Treasury adjusts their par value based on the consumer price index, a measure of inflation. The value of ordinary bonds, which typically feature fixed par values, may be eroded over time by gains in inflation.
“Indexing the bond’s value to inflation helps protect investors from an erosion in purchasing power,” says Crill. Regardless of how much prices change over the term of your TIPS investment, you maintain the purchasing power of the cash you invested—plus interest payments.
What’s more, interest payments are also adjusted for inflation each year. While the interest rate remains constant over the duration of your TIPS, the interest payment you receive every six months is based on your TIPS’ current par value, meaning they effectively increase with CPI.
While deflation is very rare, the value and interest payments of your TIPS could be adjusted downward to reflect negative CPI rates. That said, you never receive less than the original par value of the TIPS upon maturity.
TIPS and Taxes
As with most investments, TIPS earnings are subject to taxes, at least on the federal level. Earnings are generally exempt from state and local taxes. However, you have to be careful with TIPS because their earnings encompass their interest payments and any inflation adjustments that increase their par value.
“In any year when the principal value of a TIPS bond increases due to the inflation adjustment, that gain is considered reportable income for the year, even though the investor won’t receive the inflation-adjusted principal until the security matures,” says Robert Johnson, professor of finance at Heider College of Business at Creighton University.
If you don’t plan for this in advance, this may create a small unexpected tax burden, as you won’t have received the updated par value back yet but are still expected to pay income taxes on it.
In the event that deflation occurs, reducing the par value of TIPS, you may be able to use it to offset other income gains. You generally will only be able to do this if the adjustment exceeds the amount of TIPS interest you earned that year. Speak with a tax professional to determine how TIPS may affect your taxes.
Advantages of TIPS
For inflation-conscious investors, TIPS have some big advantages.
Easy Inflation Insurance
TIPS can provide an easy way to engineer an inflation hedge in your portfolio. “This is particularly important for more conservative or income-focused investors,” like those in retirement often are, says Matt Dmytryszyn, director of investments at Telemus, an investment advisory firm in Southfield, Mich.
In high-inflation environments, TIPS performance may greatly exceed that of traditional government bonds, whose fixed interest payments effectively become smaller over time.
Backed by the Full Faith and Credit of Uncle Sam
While many investments may outperform inflation over time, TIPS are the only one guaranteed to do this that also have all of the benefits of standard Treasury bonds.
“They’re supported by the full faith and credit of the U.S. government and are traded in a deep and very liquid market,” says Frederick Miller, founder of Sensible Financial Planning and Management, LLC, in Waltham, Mass.
In other words, it’s highly unlikely the U.S. government will fail to pay you back—that hasn’t happened yet in U.S. history—and, should you need to sell your TIPS before their term ends, you should be able to do so relatively easily. This makes TIPS great low-risk investments.
Disadvantages of TIPS
TIPS aren’t without their disadvantages. Here are a few of the risks you might encounter if you invest in TIPS.
- Poor performance during deflation or low inflation. While TIPS have an edge over traditional bonds when inflation runs hot, they perform poorly when deflation strikes or there is low inflations. That’s because deflation or low inflation drags down their par value, shrinking interest payments. In these conditions, TIPS fail to keep up with market interest rates.
- Unpredictable cash flow. Because their payments are dependent on inflation, it’s hard to estimate in advance what your income might be. This may not be a huge deal if payments end up being more than expected, but during periods of lower inflation or deflation, you could end up with less money coming in than you need.
- Anticipatory taxes. Because you must pay income taxes on any increases to par value, you could end up owing “phantom taxes” on money you haven’t actually earned until your TIPS mature. You can combat this by holding your TIPS in tax-advantaged retirement accounts.
- Liquidity. In general, it’s pretty easy to cash out or resell your U.S. Treasuries before their maturity date. TIPS don’t trade as much as other bonds in secondary markets, which may make it harder to sell yours quickly. During periods of unstable inflation, you also may end up selling your TIPS at a loss, especially if their par value has been adjusted to lower than what you paid.
- CPI may not match your personal inflation rate. TIPS are tied to CPI, and if your spending habits don’t completely align with the averages used to measure CPI, inflation adjustments may not compensate you for your spending patterns. “The CPI is a basket of goods and the composition of each of our baskets of goods will vary in some way from the composition CPI basket,” says Dmytryszyn. TIPS may not keep up with your personal rate of inflation.
How to Buy TIPS
You can buy TIPS through your online brokerage account or directly from the U.S. Treasury at TreasuryDirect.
If you choose to buy TIPS on the secondary market, be sure to compare how much the current inflation-adjusted par value differs from the original par value. Remember: You are only guaranteed to receive payment up to the original face value of a TIPS. If its price is above the issue price, you could lose money if deflation drags the par value to less than you paid.
That means you’ll probably only want to buy TIPS on a secondary market if the current par value is less than the issued par value. Otherwise, your safest bet may be purchasing TIPS directly from the Treasury.
You can also buy shares of mutual funds and exchange-traded funds (ETFs) that contain diversified mixes of TIPS. While buying into a TIPS fund may make certain aspects of TIPS ownership easier, such as allowing you to reinvest earnings or buy odd-dollar amounts of shares, keep in mind you’ll be paying expense ratio fees, which can negatively impact your returns.
Should You Buy TIPS?
If you’re a safety-minded investor who wants some government-backed protection against inflation, TIPS can make good sense.
“TIPS matter to Main Street investors because they can help you protect your buying power from rising inflation,” says Tom Preston, who spent 30 years as a Wall Street trader and is a market strategist for Tastytrade, a Chicago-based digital finance and investment marketplace. “When inflation increases the price of things you need to buy, the extra return from a TIPS can offset that.”
Before buying your TIPS, though, be sure to compare current bond yields to expected inflation rates. Because they adjust for inflation, TIPS interest rates tend to be much smaller than non-TIPS bonds. For instance, if bonds are yielding 3%, inflation is only 2%, and TIPS interest is 0.5%, you would only expect to earn the equivalent of 2.5% on your TIPS each year. This could make it an inferior choice to the non-TIPS Treasury. Conversely, if non-TIPS bonds were only yielding 2%, TIPS would give you an extra half a percent over traditional bonds.
According to Raymond James, the average breakeven point has been around 2.5% since the mid-1990s, meaning a non-TIPS bond must yield at least that much to hypothetically outperform a TIPS.
