TIPS: Understanding Treasury Inflation-Protected Securities

Inflation is a threat to every long-term investor, but with the right investments, you can protect yourself from the loss of purchasing power that inflation can cause. TIPS, or Treasury Inflation-Protected Securities, are a valuable weapon in your inflation-fighting arsenal.

TIPS are bonds, but they have a key characteristic that most bonds lack: Their value is tied to rises and falls in consumer prices. Later in this article, you'll learn more about TIPS and how to buy them, but first, let's examine just how detrimental inflation can be if you don't fight it.

Why inflation matters
For several years, inflation rates have been fairly subdued, so many people don't remember just what inflation can do to your wealth. During the late 1970s and early 1980s, however, everyone got a firsthand introduction to the ravages of inflation. The oil shocks of the 1970s not only pushed gasoline prices sharply higher but also contributed to higher costs that brought on rising prices throughout the economy. With prices rising at a more than 10% annual clip from 1979 to 1981, it took less than a decade for prices to double, cutting the true value of every dollar you owned in half.

For investors, inflation brought an even more devastating impact, reducing the value of their bond holdings substantially. When inflation rose, the government and other bond issuers had to raise the interest rates that their bonds paid in order to attract investors. But with high-rate bonds available, the prices of existing lower-rate bonds fell precipitously. Moreover, with prices rising so fast, bond investors found that by the time they got their principal back when their bonds matured, the money they received had only a fraction of the purchasing power of their original investment.

TIPS and inflation
In early 1997, the U.S. Treasury responded to ongoing calls for an investment that would help investors reduce inflation risk in their portfolios. By issuing Treasury Inflation-Protected Securities, or TIPS for short, the Treasury changed the way that most bonds were structured.

Before TIPS, most bonds had just two variables: how much interest you received and how long you had to wait to get your initial investment back. Once you bought a bond, you would know exactly how much money you'd get, both in interest payments on a regular basis during the lifespan of the bond as well as in your final principal payment at maturity.

But TIPS introduced a new variable by adding inflation to the mix. In particular, TIPS use the Consumer Price Index, a measure of the prices that Americans pay for a basket of goods ranging from food and housing to cars and clothing. Unlike traditional bonds, whose returns were defined solely by their interest rate, rising or falling inflation affects not only the interest you receive on TIPS but also their final value at maturity.

Every month, the government releases the latest CPI figures, and the Treasury applies those numbers to the value of TIPS. So if inflation rises by 2% in a given year, then the value of TIPS that started the year with a value of $1,000 would rise by 2% to $1,020. That increase would also apply to interest payments, so if those bonds paid 1% in interest every six months, then the next interest payment would be calculated by taking the new value of $1,020 and multiplying it by 1% to get $10.20 in interest.

Fast-forward to maturity, and what you get back from the Treasury will typically be much more than your initial investment. What you'll get is however many dollars it takes to equal the current purchasing power of your original investment, based on the CPI's change over the course of the bond's lifespan. That's how TIPS protect you against inflation.

Check them out
The trade-off is that TIPS offer much lower rates than traditional bonds. In fact, lately, some TIPS have had negative rates, meaning that investors are willing to take a certain loss of purchasing power in exchange for inflation protection. Still, TIPS are worth looking into. With TIPS available both individually from the Treasury as well as through ETFs including iShares Barclays TIPS Bond (NYSEMKT: TIP  ) , Schwab U.S. TIPS (NYSEMKT: SCHP  ) , and Vanguard Short-Term Inflation-Protected Securities Index (NASDAQ: VTIP  ) , it's never been easier to give yourself the protection from inflation that you need.

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