Treasury Inflation Protected Securities: Do They Belong in Your Portfolio?


U.S. Treasury Building, Washington, D.C. Image courtesy Wikimedia Commons.

Despite the allure of huge potential gains in the stock market, most investors need to keep at least some of their money in more conservative investments. Yet for years, investment experts have warned that rising interest rates would crush the value of most bonds, causing unexpected losses for bond investors. As fears of inflation rise, though, more investors are looking at a special type of bond known as Treasury Inflation Protected Securities, or TIPS. But do TIPS make sense for your portfolio? Let's look at what makes Treasury Inflation Protected Securities so unusual and see whether they can help you in ways that ordinary bonds can't.

Fighting against inflation with Treasury Inflation Protected Securities

For most bonds, one of the biggest threats is inflation. To buy a typical bond, you pay a fixed amount up front, agreeing to take fixed amounts of interest at various intervals. When the bond matures, you get the original amount of your investment back along with the final interest payment.

Source: U.S. Treasury.

By the time the bond matures, though, inflation has reduced the purchasing power of the money you initially invested. For instance, with a typical $1,000 30-year Treasury bond, you're guaranteed to get the $1,000 in principal back at maturity -- but by the time 30 years has passed, the purchasing power of that $1,000 will have been cut in half, even assuming modest inflation rates of around 2.5%.

The government designed Treasury Inflation Protected Securities to fight the impact of inflation. Rather than giving your original investment back, TIPS have their final payment at maturity adjusted upward to reflect inflation throughout the period. In addition, interest payments rise steadily in line with moves in the Consumer Price Index, which is the government's gauge of inflation for these purposes. As a result, using the same 2.5% inflation assumptions as above, a $1,000 30-year TIPS bond would pay out almost $2,100 at maturity 30 years from now -- equivalent to the purchasing power of $1,000 today.

The pros and cons of Treasury Inflation Protected Securities

Because TIPS are indexed to changes in inflation, the inflationary pressures that affect regular bonds leave TIPS largely unscathed. So when interest rates on regular bonds rise because of inflation, the interest rates on TIPS -- and thus the price of TIPS -- will remain relatively stable.


The Federal Reserve plays a vital role in the bond market. Image source: Dan Smith.

Moreover, from a planning standpoint, using TIPS for future income needs is easier. With regular bonds, you have to worry about the unknown impact of inflation on purchasing power. With TIPS, though, you're assured that the value of the bond at maturity will keep up with inflation.

But there are some trade-offs with Treasury Inflation Protected Securities. The most obvious is that the interest rate you get on TIPS is much lower than on regular bonds. That's because with regular bonds, the interest payments are what compensate you for inflation risk, while TIPS back-load the impact of inflation into the maturity payment. In fact, interest rates on short-term TIPS have been persistently negative in recent years, and even long-term TIPS have seen their rates stuck in a 0% to 1% range for a while now. At the same time, if interest rates on TIPS rise -- which can happen if the bond market anticipates rate increases for reasons other than inflation -- then they can lose principal value as well if not held until maturity.

Also, the way that TIPS get taxed is complicated. Even though you don't receive the inflation adjustment until the bond matures, the IRS forces you to include the rise in value that comes from inflation each and every year in your taxable income. That increases the tax cost of TIPS and makes them most suitable for use in tax-deferred retirement accounts like IRAs.

With fears of inflation starting to rise, Treasury Inflation Protected Securities are getting more attention from investors. Although they won't replace all of your allocation to the bond market, TIPS can be a good way to diversify your bond portfolio from the negative impact of inflation going forward.

Top dividend stocks for the next decade

Beyond bonds, though, the smartest investors know that dividend stocks simply crush their non-dividend paying counterparts over the long term. That's beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor's portfolio. To see our free report on these stocks, just click here now.


Read/Post Comments (1) | Recommend This Article (0)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 05, 2014, at 8:27 AM, oak5146 wrote:

    Appreciate if anyone can comment on how Tips funds are taxed; also the relative merits of TIP fund and the 15 year Pimco TIP fund.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 3089691, ~/Articles/ArticleHandler.aspx, 10/2/2014 10:38:27 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Apple's next smart device (warning, it may shock you

Apple recently recruited a secret-development "dream team" to guarantee its newest smart device was kept hidden from the public for as long as possible. But the secret is out. In fact, ABI Research predicts 485 million of this type of device will be sold per year. But one small company makes Apple's gadget possible. And its stock price has nearly unlimited room to run for early-in-the-know investors. To be one of them, and see Apple's newest smart gizmo, just click here!


Advertisement