Treasury Inflation-Protected Securities (TIPS) Explained

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.

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.

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.

You can also buy TIPS directly from your bank or broker. This may be more convenient for those investors who already have a substantial portfolio of securities at a certain financial institution.

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.

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.

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.