Key Takeaways
- Treasury Inflation Protected Securities (TIPS) are debt instruments backed by the full faith and credit of the U.S. government. As a result, they have minimal credit risk.
- As their name implies, TIPS protect investors from the wealth-eroding impact of inflation. They pay interest and ensure principal protection based on changes in the Consumer Price Index (CPI).
- Over the long term, TIPS can significantly underperform growth-oriented assets, such as stocks.
What Are Treasury Inflation-Protected Securities (TIPS)?
Treasury Inflation-Protected Securities (TIPS) are a type of bond issued by the U.S. Department of the Treasury, with terms of 5, 10 or 30 years. As their name implies, they provide investors protection against the wealth-eroding effect of inflation.
This is achieved because the principal of a TIPS issue can fluctuate monthly based on changes in the Consumer Price Index (CPI). As a result, the semiannual coupon payments of the investment are calculated using the following method:
Semiannual Coupon Payment = Inflation-adjusted Principal Value × Fixed Coupon Rate ÷ 2
Upon maturity of the bond, if the inflation-adjusted principal is higher than the original principal, the higher amount is paid to the investor. Alternatively, if the inflation-adjusted principal is equal to or lower than the original principal, the original amount is paid to the investor.
When a TIPS instrument is issued, the fixed coupon rate reflects the prevailing real rate of interest, adjusted for market assumptions of future inflation (with a floor of 0.125%). Generally, this will be slightly lower than the nominal rate offered by a regular Treasury bond with a comparable term.
Treasury Inflation-Protected Securities (TIPS) can provide a buffer in the bond portion of your portfolio by providing some protection against rising prices.
Toby Walters, CFA®Senior Financial AnalystToby Walters, CFA®, is a senior financial analyst with over 25 years of experience in financial research. His knowledge spans researching and analyzing financial data to developing a one-of-a-kind viewpoint on money-related topics.
What Are the Pros and Cons of Investing in TIPS?
TIPS are incredibly safe debt instruments issued by the U.S. government. They are free from both credit and inflation risks and, generally, exhibit a high degree of liquidity.
That said, TIPS do have some disadvantages. Most notably they are sensitive to interest rate changes and can underperform growth-oriented assets, such as stocks.
Pros & Cons of TIPS
Pros
- Minimal credit risk
- Provide an excellent hedge against inflation (as measured by the CPI)
- Adjustable nature helps preserve purchasing power
- Very safe investment and can serve as a stabilizing force in a portfolio
- Exempt from state and local income tax
Cons
- Limited term lengths (5, 10 or 30 years)
- Exposed to deflation, which can result in lower interest payments
- Exposed to interest rate risk
- Relatively low-yielding and likely to underperform growth-oriented assets over long periods
- Subject to federal income tax
How Do TIPS Compare to Other Investments?
The closest alternatives to TIPS are other U.S. debt securities, such as regular Treasury securities and Series I savings bonds (I bonds). Both types of vehicles are backed by the full faith and credit of the U.S. government and can generate interest income for long periods of time.
Regular Treasuries do not provide protection against inflation, but they usually offer higher yields than TIPS to compensate investors for assuming the additional risk. I bonds do provide inflation protection.
Another key distinction between TIPS and I bonds relates to their marketability. TIPS are marketable, which means you can buy or sell them on secondary markets. I bonds are non-marketable, which means you cannot trade them on secondary markets. Purchases and redemptions must be transacted directly with the U.S. Department of the Treasury.
Regular Treasury securities consist of bills, notes and bonds. Bills have maturities of 30 days to one year and are zero-coupon instruments. Notes have maturities between 2 and 10 years and make regular interest payments. Bonds have maturities greater than 10 years and make regular interest payments.
How Do I Invest in TIPS?
You can invest in TIPS via the primary market or the secondary market. The primary market is the forum where the U.S. Department of the Treasury issues debt directly to retail and institutional investors.
Primary market purchases can be made via TreasuryDirect (non-competitive bids only) or through a bank, broker or dealer (competitive and non-competitive bids). The minimum amount you can purchase of any given bond via TreasuryDirect is $100; additional amounts must be in multiples of $100 (up to a maximum of $10 million for non-competitive bids).
The secondary market is the forum where investors trade previously issued TIPS with each other. To execute transactions in this market, investors must do so through a bank, broker or dealer. However, secondary market participation does not always involve buying individual TIPS.
In many cases, investors gain exposure to TIPS via index mutual funds and exchange-traded funds (ETFs), such as Vanguard’s Inflation-Protected Securities Fund Investor Shares (ticker: VIPSX) and iShare’s TIPS Bond ETF (ticker: TIP). Each vehicle provides share-based ownership of an underlying basket of TIPS and makes periodic income distributions to shareholders.
Are TIPS a Good Investment
Treasury Inflation-Protected Securities are not necessarily a good or bad investment. They make sense for some people but can be suboptimal for others.
The suitability of TIPS is dependent on your investment objectives and tolerance for risk. Along these lines, investment allocation decisions should always be made in a portfolio context — with appreciation for the diversification benefit of combining assets with dissimilar risks.
Frequently Asked Questions About TIPS
TIPS are usually a good investment for conservative, income-focused investors who are concerned about inflation risk. TIPS are usually a poor investment for growth-oriented investors with long investing horizons and the ability to endure stock market volatility. To assess your specific situation, consult a fiduciary financial advisor.
If your investing horizon is short (less than a year), many investment vehicles offer a better risk-return profile than TIPS. The vehicle at the top of the list is a high-yield savings account. Alternatively, you may want to put your money in a certificate of deposit (CD).
TIPS are designed to keep pace with inflation and compensate investors with a yield that maintains the real value of their investment. As a result, inflationary changes have minimal impact on TIPS performance.
Typically, a bond’s price decreases as market interest rates rise. Conversely, a bond’s price increases as market rates fall. The extent of the price change depends on the duration of the bond – which is a measure of the number of years it takes to regain an initial investment. Generally, the longer the duration, the more sensitive a bond’s price is to interest rate movements.
TIPS are not exempt from this fundamental rule. While they are designed to provide protection against inflation, if interest rates increase in excess of the rate of inflation, TIPS will inevitably lose value.
Any interest you earn on TIPS is subject to federal income tax, and any change in the value of your principal may affect your taxes. However, TIPS income is generally exempt from state and local income tax.
Editor Malori Malone contributed to this article.
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