What Are TIPS? A Complete Guide to Treasury Inflation-Protected Securities and How They Work

TIPS are government-backed bonds that adjust for inflation and help protect purchasing power over the long term. They offer semi-annual interest, preserve principal, and may suit conservative investors or retirees seeking protection against rising living costs.

By Douglas Wade, Attorney

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Table of Contents

1. What are TIPS?

2. The price of TIPS in relation to inflation

3. How to purchase TIPS

4. Pros and Cons of TIPS

5. TIPS’s ideal investor type

6. What are TIPS & Nominal Bonds?

7. What is the performance of TIPS?

8. How can I buy TIPS?

9. Is it possible to purchase TIPS for my own personal retirement account?

10. What are TIPS’ yields?

11. Why are TIPS issued by the Treasury?

12. The Final Word

What are TIPS?

TIPS (Treasury inflation-protected securities) shield investors from a drop in the overall value of their capital. TIPS have an indexing to inflation.

Important Takeaways

Treasury bonds known as TIPS (Treasury Inflation-Protected Securities) are linked to an inflationary measure to shield investors from a drop in the value of their funds.
TIPS principal value increases in tandem with inflation, whereas the bond’s adjusted principal value determines the interest payment.
Investors will never get less than the initial principal they invested, protecting the principal amount.

As inflation increases, TIPS’s primary value increases as well. The CPI (Consumer Price Index), which measures the rate of price increases across the U.S. economy, is known as inflation. When the rise in real earnings does not increase proportionately to counteract the adverse consequences of rising prices, inflation becomes a problem.

TIPS are a common asset for both earning from and protecting portfolios against inflation because they provide interest at a fixed rate that is established at the bond’s auction every 6 months. However, because the rate depends on the bond’s modified principal or value, the interest sums paid may differ.

In the event that growing prices cause the principal amount to increase over time, the rate of interest shall be multiplied by the principal amount. As inflation increases, investors consequently receive larger interest or payments for coupons. Deflation, on the other hand, will result in smaller interest payments to investors.

Because they are backed by the U.S. government, TIPS are regarded as low-risk investments and come with durations of five, ten, and thirty years. When TIPS matures, they return either the initial principal or the modified principal, whatever is higher.

TIPS are offered with the previously listed maturities and can be bought straight from the federal government via the TreasuryDirect system in 100-dollar increments and require a $100 minimum investment.

For some investors, TIPS is best obtained through an ETF (exchange-traded fund) or a TIPS mutual fund. When investors buy TIPS directly, however, they can avoid the mutual fund management expenses.

The price of TIPS in relation to inflation

TIPS are crucial because they help mitigate the increase in inflation risk that reduces fixed-rate bond yields. Since most bonds have a fixed rate of interest for the duration of the bond, the risk of inflation is a concern. Consequently, the interest payments on the bond may not be able to keep pace with inflation. For instance, an investor experiences a real net loss if prices increase by 3% and their bond yields 2%.

TIPS are intended to shield investors from the negative consequences of compound interest rate increases over the bond’s duration. The CPI measures the par value, or principal, which rises with inflation and falls with deflation. The adjusted-for-inflation principal or the initial principal, whichever is higher, is distributed to bondholders upon TIPS maturity, as previously stated.

At year’s end, let’s say an investor has 1,000 dollars in TIPS with a 1% coupon rate. In the event that the CPI shows no inflation, the investor will get 10 dollars in payments for coupons for that year. But if inflation increases by 2%, the one-thousand-dollar principal will increase by two percent to $1,020. To get the interest charge of $10.20 for the duration of the year, the coupon rate, which stays at 1%, will be multiplied by the modified principal of $1,020.

The principal will be reduced to $950 in the event that prices fall 5% due to deflation, or negative inflation. Over the course of the year, the interest payment will come to $9.50. However, the investor would get at least $1,000 in principal at maturity, or an amended higher principal if applicable.

Although the investor is not in danger of losing the initial principal provided the bond remains outstanding until maturity, the interest due during the bond’s life may be determined using a lower principal value in the case of deflation. Investors may receive a smaller amount than the original principal if they resell TIPS in a secondary marketplace before they mature.

Important: TIPS are ineffective as a short-term inflation hedge. Their actual purpose is to shield investors against long-term increases in living expenses.

How to purchase TIPS

After knowing ‘What are TIPS?’ we will discuss the ways to purchase them. Investors can purchase TIPS from the website of the U.S. government via TreasuryDirect.gov, just like they can purchase different Treasury securities. This involves a multi-layered security login process that is a bit complex.

Another option is to purchase TIPS straight from your broker or bank. Investors who now hold an extensive holding of securities at a particular financial institution may find this more convenient.

Pros and Cons of TIPS

What are the Pros?

The benefits of Treasury inflation-protected securities will be discussed next. The advantages consist of, but are not exclusive to:

Inflation Protection: It should be clear by now that TIPS are designed with the express purpose of protecting investors from inflation. TIPS principal is modified in response to shifts in the CPI.
Safety & Stability: TIPS’s stability and security are among its most attractive benefits. TIPS can typically be seen as having a lower default risk because they are created and supported by the United States government.
Interest payments on a regular basis: TIPS offers semi-annual payments of interest to investors who seek regular cash flow. This characteristic can be very significant, particularly for retirees or others who require a consistent and possibly growing income.
Potential for Capital Appreciation: However, TIPS may potentially increase in value. TIPS’s primary value rises in tandem with inflation. Investors may see gains in capital if they decide to part with their TIPS before they mature, particularly in times of high inflation.
Tax Benefits: Investors in states with high tax rates can profit from TIPS’s tax benefits. Although TIPS interest income is not subject to state or local taxes, it is liable to federal tax.
Diversification: TIPS can improve the diversification of an investment strategy. Even if the relationship between assets is constantly changing, TIPS may behave differently from different types of assets that can react adversely to inflation and price increases.
Liquidity: Last but not least, TIPS are extremely liquid stocks. The secondary marketplace makes it quite easy to buy and sell them. Because of this liquidity, if you have to sell, you can do it really fast and not be concerned as much about becoming trapped with your investment.

TIPS Cons

There are certain drawbacks to take into account in addition to those benefits.

Lower Yield in Comparison to Alternative Bonds: TIPS often have lower yields than other bond categories. This is due to their generally lower risk (since they are given out by the government).
Taxation of Inflation Adjustments: Another major drawback of TIPS is that inflation adjustments are taxed. Inflation raises the TIPS principal value, but even if the investor doesn’t receive this money till the security expires or is sold, the increase is subject to tax in the year it happens. This implies that taxpayers would be required to pay taxes on income that they haven’t yet received.
Deflation Risks: TIPS are less helpful in times of deflation, even as they guard against inflation. TIPS’s primary value is lowered if the CPI declines. When the entire worth of the security declines, this lowers the total return on the money invested.
Problems with Liquidity During Crisis: We noted that liquidity is a benefit. The liquid nature of TIPS, however, may not be optimal during times of market stress or financial crises. Even though TIPS are often liquid, selling them may be more difficult in certain market situations. Selling (or at least selling for the price you’d like to) might be challenging when several individuals are looking to cash out around the same moment.
Opportunity Cost: In a broad sense, there may be opportunity costs associated with TIPS investment. TIPS is typically not so much a thriving investment opportunity as it is a risk buffer. Even if there are continuously changing market opportunities, investors could miss out on chances to increase their profits.

TIPS’s ideal investor type

Clearly, TIPS are best suited for specific investment types. When we discussed the benefits and drawbacks, we mentioned a few of those investors in passing. We will now discuss those investors in further detail, beginning with those who are conservative.

For cautious investors who value capital preservation and want to reduce risk, TIPS are perfect. People consider TIPS safe as it is backed by the United States government. To have steady cash flow in the future, many institutions often depend on TIPS to keep their long-term investments free from inflation.

Anyone who wants a regular income post-retirement should consider TIPS. The half-yearly interest payments, which have been corrected for inflation, as we discussed previously, offer a steady income that keeps up with the increasing expenses of living. Those who might be preparing for retirement can also benefit greatly from TIPS. Although TIPS may be the greatest investment plan for investors who are certain that there will be an elevated level of inflation for decades to come, it is also available to those with long-term plans who are worried about the effects of inflation over longer periods of time.

TIPS could be helpful for investors who are concerned about municipal and state taxes. TIPS ownership offers several state and local tax advantages, as we previously discussed. ESG investors may also be other types of niche investors. An investor may opt to purchase fixed-income securities issued by organizations (in this case, the government) that share their ESG values if they do not agree with the company’s ESG policies and instead support the laws now in effect.

What are TIPS & Nominal Bonds?

The distinction between TIPS and nominal bonds will be briefly discussed. Although the U.S. Treasury issues both TIPS and nominal bonds, their primary distinction is how they approach inflation protection. The principal amount of nominal bonds, sometimes referred to as conventional bonds, stays the same until they mature, and they pay a fixed rate of interest during their whole term. They don’t offer specific inflation protection. In contrast, TIPS are particularly made to shield owners from inflation.

Fixed interest payments on nominal bonds are determined by the bond’s face value. Inflation is not taken into account when making such coupon payments. These nominal bonds’ market price varies depending on the interest rate and other market factors. Nominal bond yields are fixed.

Both TIPS and nominal bond interest income are taxable at the federal level. On the other hand, TIPS principal adjustments for inflation are also subject to income tax during the year in which they take place. Nominal bonds are not like this.

What is the performance of TIPS?

A large number of investors turned to TIPS for safety in 2022 as U.S. inflation reached levels not seen in forty years. But that insurance coverage didn’t exactly work out as planned. These inflation-protecting assets did not fare much better than standard Treasuries and the main equity markets, falling by a mean of 14.2% throughout the year.

The way TIPS operate and how frequently they are misunderstood is brought to light by this. The Federal Reserve, as it usually does when the cost of living skyrockets, raised interest rates in 2022 when inflation skyrocketed. Despite the additional inflation-linked payouts, TIPS, just like the remainder of the bond sector, have dropped in value due to sharp rises in borrowing costs.

TIPS underperformed in 2023 as inflation subsided and the Fed cut interest rates. The TIPS Bond ETF gained $1.05 across the year, yielding a yearly return of 0.99% from 1^st Jan 2023 to 31^st Dec 2023. The majority of this gain was given back during the first few months of 2024; the ETF lost 0.73% from the beginning of the year to the conclusion of March 2024.

How can I buy TIPS?

With a $100 minimum purchase amount, TIPS may be purchased directly via the TreasuryDirect website of the United States Treasury.

Usually, you can purchase them via your broker as well. TIPS along with additional inflation-linked instruments are also invested in by a number of mutual funds and ETFs (exchange-traded funds), which you may purchase and sell like regular stock.

Is it possible to purchase TIPS for my own personal retirement account?

Yes. TIPS and institutions holding TIPS may be included in an IRA, but you are not permitted to purchase TIPS directly in an IRA through the TreasuryDirect program. Rather, you would have to depend on the broker that is in charge of your retirement fund.

What are TIPS’ yields?

TIPS yields tend to be negative. This happens because the actual yield is negative after accounting for the consequences of inflation. The actual yield is minus 1%, for example, if inflation is two percent and the yield on ordinary 2-year Treasuries is one percent.

TIPS are designed to stay in line with inflation, not to outpace it. As a result, even though TIPS has a positive nominal yield, its true yield is almost zero. TIPS may have a negative yield, but their principal will rise in line with inflation, potentially leading to capital gains.

Why are TIPS issued by the Treasury?

The first TIPS was released in 1997. Their appearance is officially explained by the high demand for inflation-linked securities issued by governments from the general public.

However, because TIPS are essentially a more costly form of borrowing than conventional Treasuries, several economists have expressed confusion regarding the government’s continuous issuance of them.

The Final Word

Hope you have now understood ‘What are TIPS?’ TIPS is one of the several debt instruments that the United States Treasury Department offers. They are similar to Treasuries, but they are protected from increases in the cost of living by having their principal value linked to inflation. But they are frequently misinterpreted.

Since the majority of these securities have a lower rate of return than other comparable government bonds, it’s critical to understand that inflation insurance comes at a price. Additionally, keep in mind that bondholders receive payment at maturity of either the original principal or the inflation-adjusted principal, whichever is higher. To put it another way, safeguards are in place for times when deflation is severe.

Another widespread misunderstanding when trying to know ‘What are TIPS?’ is that TIPS are sure to perform well during periods of rising inflation and serve as an excellent short-term hedge against unexpected increases in living expenses. TIPS are ultimately bonds, as 2022 showed us, and bond markets have a negative response to increasing interest rates.

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What Are TIPS? A Complete Guide to Treasury Inflation-Protected Securities and How They Work

What are TIPS?

The price of TIPS in relation to inflation

How to purchase TIPS

Pros and Cons of TIPS

TIPS’s ideal investor type

What are TIPS & Nominal Bonds?

What is the performance of TIPS?

How can I buy TIPS?

Is it possible to purchase TIPS for my own personal retirement account?

What are TIPS’ yields?

Why are TIPS issued by the Treasury?

The Final Word

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