TIPS ETFs: What They Are and How They Work

Definition

Treasury Inflation-Protected Securities (TIPS) exchange-traded funds (ETFs) primarily hold a type of U.S. government bond designed to protect investors from inflation.

Treasury Inflation-Protected securities (TIPS) exchange-traded funds (ETFs) mainly hold U.S. government bonds designed to protect investors against inflation. The principal value of TIPS rises and falls based on the Consumer Price Index (CPI).

TIPS ETFs hold a portfolio of TIPS bonds with varying maturities. By investing in these ETFs, you gain exposure to the TIPS market in one security from an ETF that trades on the major stock exchanges. As inflation rises, the value of TIPS bonds increases, as does the net asset value (NAV) of the ETF.

TIPS ETFs can be a good fixed-income option for investors to hedge inflation risk. They provide easy access to the benefits of TIPS with the convenience, diversification, and flexibility of ETFs.

Key Takeaways

TIPS exchange-based funds (ETFs) give investors exposure to Treasury Inflation-Protected Securities (TIPS).
Factors to consider when investing in TIPS ETFs include expense ratios, liquidity, tracking errors, and diversification.
TIPS ETFs can be bought through brokerage platforms, and investors should research different options before investing.

Understanding TIPS ETFs

TIPS ETFs are constructed by buying and holding a basket of TIPS tracking a specific TIPS index, as with the Bloomberg Barclays U.S. Treasury Inflation-Protected Securities Index. The index comprises TIPS with at least one year remaining until maturity and is weighted by the adjusted market capitalization of each bond.

TIPS ETFs may use sampling techniques to replicate the index’s performance or hold all the bonds in the index.

What Are TIPS?

A key feature of TIPS, first offered by the Treasury in the late 1990s, is that the principal value adjusts upward or downward in line with the Consumer Price Index, a standard measure of inflation. When inflation goes up, the principal value of TIPS increases. When inflation goes down, the principal decreases. These adjustments help TIPS maintain a real rate of return when factoring in inflation.

For example, suppose an investor buys a $1,000 face-value TIPS with a coupon rate of 1.0%. The following year, inflation rises 3%, so the principal would adjust to about $1,030 to offset inflation. The interest payment would be based on the new inflated principal value: 1% of $1,030 = $10.30.

TIPS also have a fixed coupon rate (i.e., interest payments), which are paid out semiannually. The coupon payments stay the same throughout the bond’s life, while the principal value fluctuates according to the CPI.

When TIPS mature, investors are paid back the inflation-adjusted principal or the original principal, whichever is higher. This provides downside protection against deflation.

Unlike individual TIPS, where interest payments are made semiannually, TIPS ETFs typically distribute dividends to investors more frequently, often monthly. These dividends include interest payments from the underlying TIPS and any capital gains. The TIPS ETF might not pay a monthly distribution if there is deflation.

Purchasing a TIPS ETF vs. Direct Ownership of TIPS
Aspect	TIPS ETFs	Direct TIPS
Accessibility	Bought and sold anytime, like stocks, through brokerage accounts	Bought through TreasuryDirect, brokers, or during auctions held at specific intervals
Liquidity	High liquidity and can be traded throughout the day on stock exchanges	Less liquid and can be harder to sell quickly at market value
Investment Minimum	Lower minimum investment, depending on the price of a single ETF share; if fractional shares are allowed, this could be even lower	Higher minimum investment, usually $100 for new issues
Diversification	Offers instant diversification across a range of TIPS maturities	No diversification with a single TIPS purchase
Interest Payments	Typically distribute dividends (interest payments and capital gains) more frequently, often monthly	Pay interest semiannually
Expense Ratio	You have to pay management fees or expense ratios	No ongoing management fees
Price	Market price can be above or below the TIPS’ NAV	Priced at par value at auction, but the market price can vary afterward
Tax Considerations	Interest and capital gains are taxable	Often exempt from state and local taxes, but federal taxes apply
Management	Professionally managed by the ETF provider	Self-managed, unless held in a managed account

TIPS ETFs Benefits

Here are some key benefits of investing in TIPS ETFs:

Inflation hedge: ETFs offer easy access to inflation-protected securities that can help hedge against an investment portfolio’s inflation risk. As inflation rises, so does the principal value of the underlying TIPS.
Diversification: This is the strategy of spreading investments across different asset classes, sectors, regions, and styles to cut the overall risk and volatility of a portfolio. Adding TIPS ETFs to a portfolio can diversify beyond equities and conventional bonds. They have a low correlation with the prices of stocks and nominal bonds. In addition, TIPS ETFs provide easy access to inflation-protected bonds without building a ladder for individual TIPS bonds yourself.
Convenience and liquidity: TIPS ETFs trade daily on major exchanges so that they can be bought and sold quickly via brokerage platforms throughout the day. Many brokerages also offer commission-free trading in ETFs. As the underlying TIPS mature, TIPS ETFs roll them over to maintain their target maturity range.

Lower investment minimums: You have a lower minimum investment when buying shares in TIPS ETFs than when buying individual TIPS directly. You would need to invest in increments of $100 to buy TIPS via TreasuryDirect, but you can typically use any amount to buy fractional shares in a TIPS ETF.

TIPS ETFs Risks and Drawbacks

While TIPS ETFs have many advantages, there are some potential downsides to consider:

Higher expenses: TIPS bought directly do not have any fees attached. TIPS ETFs, however, have expense ratios that cover the ETF’s administrative costs. These can range from 0.10% to 0.20% or more per year. This eats into returns slightly more than when buying TIPS directly. However, for smaller investors, the convenience and diversification of TIPS ETFs may counteract the marginally higher expenses.
Tracking error: TIPS ETFs aim to track the performance of the overall TIPS market, but there will inherently be some tracking errors. The particular index chosen, fund flows, maturity mismatches, and manager skills can cause ETF returns to diverge somewhat from the TIPS market. Actively managed TIPS ETFs tend to have more tracking errors and higher fees.
Liquidity mismatches: While ETFs are liquid, the underlying TIPS market can have periods of diminished liquidity, which can hamper the fund’s ability to trade or efficiently roll over into new TIPS at maturity.
Interest rate risks: TIPS ETFs have interest rate risks like conventional bonds and bond ETFs. When interest rates rise, the value of the existing bonds falls. This means rising rates could lead to price declines in the portfolios of TIPS ETFs. Hence, they can still lose value when there’s a rise in inflation if interest rates are rising at a faster pace than the CPI.

Tax drag: The inflation adjustments to the principal are taxable even though the investor does not receive any cash flow from them. This could create a tax drag on after-tax returns.

Understanding these tradeoffs can help investors decide if a TIPS ETF makes sense for their portfolio or if owning TIPS directly may be preferable. Consulting a financial advisor can help analyze the pros and cons.

TIPS are designed to provide inflation protection by adjusting their principal value based on changes in the CPI. This adjustment helps their value maintain purchasing power as inflation rises. However, TIPS and TIPS ETFs may not fully offset high or sudden inflation. For example, the CPI measure might underestimate inflation, limiting their protection.

Factors to Consider When Investing in TIPS ETFs

The iShares TIPS Bond ETF (TIP) was the first TIPS ETF, launched in 2003 by BlackRock Financial Management. It’s the largest TIPS ETF in assets under management, with $18.7 billion as of early 2024.

According to the VettaFi ETF Database, about 20 TIPS ETFs were trading in the United States in early 2024. These ETFs vary in duration, expense ratio, dividend yield, and performance. Popular TIPS ETFs include the Vanguard Short-Term Inflation-Protected Securities ETF (VTIP), the Schwab U.S. TIPS ETF (SCHP), and the PIMCO 15+ Year U.S. TIPS Index Fund (LTPZ).

If you’re considering a TIPS ETF, here’s what you’ll want to consider:

TIPS ETF Factors to Consider
Factor	Description	Examples
Expense Ratio	The expense ratio is the fee that ETFs charge to cover operating costs, expressed as a percentage of the fund’s NAV. A lower expense ratio means a higher return for investors.	The Vanguard Short-Term Inflation-Protected Securities ETF has an expense ratio of 0.04%, while the iShares TIPS Bond ETF has an expense ratio of 0.19%.
Liquidity	The trading volume and the bid-ask spread measure the ease with which an ETF can be bought or sold in the market without affecting its price. Higher liquidity means lower transaction costs and a more efficient market for investors.	The iShares TIPS Bond ETF is the most active, with an average daily trading volume of nearly 3 million shares. The JPMorgan BetaBuilders U.S. TIPS 0–5 Year ETF (BBIP) is the least liquid TIPS ETF, with an average daily trading volume of just 200 shares.
Tracking Error	The difference between the performance of ETFs and its benchmark index is influenced by sampling techniques, fund expenses, rebalancing frequency, and market conditions. A lower tracking error means a higher correlation and a more accurate replication of the index.	ETFs with low tracking errors may correlate with its 98%–99% benchmark index. A high tracking error may be closer to 93%–95%.
Diversification and Duration	TIPS ETFs offer diversification benefits for investors, as they have low or negative correlations with other asset classes. TIPS ETFs also have different durations, which measure the sensitivity of bond prices to changes in interest rates.	The SPDR Portfolio TIPS ETF (SPIP) holds 50 individual TIPS securities with an average duration of 5.25 years. The Dimensional Inflation-Protected Securities ETF (DFIP) has only 17 holdings and an average duration of 5.50 years.

Data as of January 2024

Are TIPS ETFs an Effective Hedge Against Inflation?

TIPS can offer valuable long-term inflation protection, but they are not a perfect hedge. Historically, they have kept up with or outperformed the rate of inflation, especially over longer time horizons.

Investors should use TIPS ETFs as part of a broadly diversified portfolio and have realistic expectations about their inflation-fighting abilities. Consulting with a financial advisor can help determine the right role for TIPS for you.

How Can I Invest in TIPS ETFs?

Investing in TIPS ETFs is straightforward, as these trade like any other stock or ETF through your brokerage account. If you have such an account, simply research and identify the TIPS ETF you’d like to trade and then do so like any other shares on your broker’s platform.

What Are the Main Factors Driving TIPS ETF Returns?

Inflation, interest rates, duration, and market conditions all influence TIPS ETF returns, which benefit from rising inflation as their principal and interest payments increase with the CPI. However, TIPS ETFs also suffer from rising interest rates, as their bond prices decrease as rates rise like other bonds. The duration of TIPS ETFs will also matter, as longer-duration TIPS ETFs have higher price sensitivity to interest rate changes. In contrast, shorter-duration TIPS ETFs often have lower returns but lower risks.

TIPS ETFs generally tend to do well when inflation is high and interest rates are low, and vice versa. Also, pay attention to the expense ratios with these ETFs, as more costly ETFs will eat into your net returns more than lower-cost ones, all else being equal.

Which Are the Best-Performing TIPS ETFs?

The actual performance of a TIPS ETF will depend on several factors and the period considered. According to the VettaFi ETF Database, the best-performing TIPS ETF over the past five-year period has been the FlexShares iBoxx 3-Year Target Duration TIPS Index Fund (TDTT), with an average annualized return of 3.36% and the Vanguard Short-Term Inflation-Protected Securities ETF at 3.34%. These returns exceed the trailing five-year average annualized inflation rate of 2.25% during the same period. However, if you look at three-year trailing returns, the Vanguard Short-Term Inflation-Protected Securities ETF leads with 2.40%, followed by the iShares 0–5 Year TIPS Bond ETF (STIP) at 2.32%.

What Are the Risks of Investing in TIPS ETFs During Downturns?

TIPS ETFs can underperform the broader market during market downturns or economic recessions, especially when inflation is low or negative. TIPS ETFs benefit from rising inflation as their principal and interest payments increase with the CPI. However, when inflation is low or negative, TIPS ETFs can lose value as their principal and interest payments decrease with the CPI and interest rates fall.

Traditional Treasurys, meanwhile, have a fixed nominal interest rate that does not depend on inflation. Therefore, when inflation is low or negative, traditional Treasurys or bond ETFs can offer higher returns than TIPS ETFs.

The Bottom Line

TIPS ETFs act as an inflation hedge for investors. These ETFs trade like ordinary shares of stock and offer convenience to investors who can trade them from their brokerage platforms. They offer diversification, lower investment thresholds than directly purchasing TIPS from the Treasury, enhanced liquidity, and regular income streams.

However, understanding the potential for tracking errors and their tax implications is essential for informed investment decisions. You can choose among several TIPS ETFs with different durations, expense ratios, and liquidity levels.

Investing in TIPS ETFs, like any investment, involves risks, including market fluctuations and potential loss of principal. It’s advisable to consult with a financial advisor for personalized advice tailored to your specific situation.