Treasury Inflation-Protected Securities, or TIPS, are U.S. government-issued bonds that adjust in value according to inflation trends. Let's explore how TIPS work so you can decide whether this debt security is right for you.
Understanding TIPS
A standard fixed-rate bond pays interest periodically and then repays the principal when the bond matures. The principal is the amount you initially paid to purchase the bond.
If you hold the bond for decades, the principal you receive at maturity will have less purchasing power than when you initially invested. This is due to inflation, the natural increase in prices for goods and services over time.
How TIPS work
TIPS use principal adjustments to combat this loss of purchasing power. These adjustments occur every six months and are calculated from changes in the Consumer Price Index for All Urban Consumers, or CPI-U, a common measure of inflation.
When the CPI-U rises, your TIPS principal is adjusted higher by a factor representing the CPI-U increase. When the CPI-U falls, your TIPS principal is adjusted down in the same fashion.
TIPS are also designed to protect your starting principal. At maturity, you will receive either the inflation-adjusted or original principal, whichever is more. In other words, you will never be repaid less than you spent on your initial investment.
TIPS pay interest every six months. The interest rate is fixed, but the payments will rise or fall when principal adjustments are made. TIPS bonds are available in five-, 10-, or 30-year maturities.
Advantages and disadvantages of TIPS
The advantages of TIPS include:
- Inflation protection. The inflation protection preserves the purchasing power of your TIPS investment and income.
- Safety. TIPS are issued by the U.S. Treasury, and the risk of default is low.
- Liquidity. TIPS can be bought and sold on the secondary market. Since there is ongoing demand for these securities, they can be liquidated quickly.
- Exempt from state and local taxes. TIPS interest payments are subject to federal taxes but exempt from state and local taxes.
The disadvantages of TIPS include:
- Low yields. TIPS yields are low relative to debt securities without inflation protection.
- Taxable principal adjustments. An adjustment that increases the principal value is treated as federally taxable income in the year it happens.
- Potential for negative principal adjustments. If the CPI-U turns negative, your TIPS principal will be adjusted down. Your income payments would also decline since they are calculated from the principal value.
When to buy TIPS
TIPS are low-risk, low-yield securities. They do protect the purchasing power of your invested capital, but they will not appreciate the way stocks or real estate can. As such, these securities are most appropriate for diversification and capital preservation purposes.
Young, risk-tolerant investors are usually more suited to high-yield savings combined with stock portfolios rather than TIPS. The exception would be the younger investor who expects a cycle of high inflation. A small allocation to TIPS could be a hedge against that scenario. Older and risk-averse investors may want to hold somewhat larger TIPS positions, particularly if concerned about inflation risk.
It is always important, however, to evaluate the opportunity cost of holding TIPS bonds. Inflation protection is a perk that usually requires you to accept a lower yield. Reviewing your investing options could reveal that the yield differential is too high. In other words, you might forgo inflation protection in favor of better yields on other government bonds or even high-yield cash deposits.
TIPS in practice
Understanding the math behind TIPS principal adjustments can help you evaluate what inflation protection is worth. Let's assume you purchased $1,000 worth of 10-year TIPS in July 2018. The interest rate on that issue was 0.75%, and the reference CPI value was 251.01658.
Your initial interest payment on this bond is $3.75 every six months. The amount is calculated as $1,000 multiplied by 0.75% and divided by 2. Dividing by 2 converts one year of interest to your twice-annual payment amount.
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At the end of 2024, six-and-a-half years later, you want to estimate your next interest payment and TIPS principal value. The CPI has risen to 315.49852. Your first step is to calculate the index ratio, which is the current CPI value divided by the original value. In this case, that ratio is 1.25688.
Your current principal value is the index ratio multiplied by the original principal, which equals $1,256.88. That means your next interest payment should be roughly $4.71. In the six-and-a-half years since issuance, inflation protection has added $256.88 to your principal value and $0.96 to your twice-annual interest payments.
The 2018-2024 period did include high inflation in the U.S. Future adjustments over similar timeframes will likely be smaller.
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