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.

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

Pros of TIPS

Let's discuss the advantages of treasury inflation-protected securities. The benefits include but aren't necessarily limited to:

• Inflation Protection: By this point, it should be obvious that TIPS are specifically structured to safeguard investors against inflation. The principal amount of TIPS is adjusted based on changes in the CPI. 
• Safety and Stability: One of the most compelling advantages of TIPS is their safety and stability. TIPS are issued and backed by the U.S. government, meaning they (usually) can be considered lower risk of default.
• Regular Interest Payments: For investors wanting some cash flow, TIPS provide semi-annual interest payments. This feature can be quite important, especially to retirees or those who need to receive a steady and potentially increasing income. 
• Capital Appreciation Potential: On the other hand, TIPS can also rise in value. As inflation rises, the principal value of TIPS is adjusted upward. If investors choose to sell their TIPS before maturity, they may realize capital gains, especially during periods of high inflation. 
• Tax Advantages: TIPS offer tax benefits, particularly for investors in high-tax states. While the interest income from TIPS is subject to federal income tax, it is exempt from state and local taxes. 
• Diversification: Including TIPS in an investment portfolio can enhance portfolio diversification. Though the correlation between investments is always shifting, TIPS can perform differently from other asset classes that may act negatively towards rising prices and inflation. 
• Market Liquidity: Last, TIPS are highly liquid securities. They can be bought and sold with relative ease in the secondary market. This liquidity means that you don’t have to worry as much about getting stuck with your investment if you do need to sell and sell relatively quickly.

Cons of TIPS

Along with those advantages, there are some disadvantages to consider. 

• Lower Yield Compared to Other Bonds: TIPS typically offer lower yields compared to other types of bonds. This is because they tend to carry less risk (because they are issued by the government).
• Inflation Adjustment Taxation: One significant disadvantage of TIPS is the taxation of inflation adjustments. While the principal value of TIPS increases with inflation, this increase is considered taxable income in the year it occurs, even though the investor does not receive this amount until the security matures or is sold. This means taxpayers would have to pay tax on something for which they didn’t receive the cash (yet). 
• Deflation Risk: Although TIPS protect against inflation, they are less beneficial during deflationary periods. If the CPI decreases, the principal value of TIPS is adjusted downward. This reduces the overall return on the investment as the overall value of the security decreases.
• Liquidity Issues in Times of Crisis: We mentioned that liquidity was an advantage. However, during financial crises or periods of market stress, the liquidity of TIPS can be less than ideal. While TIPS are generally liquid, extreme market conditions can make it harder to sell them. When lots of people are trying to cash out at the same time, it may be difficult to sell (or at least sell for the price you want to).  
• Opportunity Cost: Very broadly speaking, investing in TIPS might involve opportunity costs. TIPS is generally more of a risk hedge as opposed to a booming investment opportunity. Though market opportunities are always in flux, investors may lose out on opportunities where they could have earned more money (by taking on more risk). 
  

Best Type of Investor for TIPS

TIPS are definitely best designed for certain types of investors. Some of those investors were briefly touched on when we talked about advantages and disadvantages. More specifically, we’ll talk about those investors now, and we’ll start with conservative investors. TIPS are ideal for conservative investors who prioritize capital preservation and seek to minimize risk. Since TIPS are backed by the U.S. government, they are considered one of the safest investment options available. For this reason, institutional investors such as pension funds and insurance companies often use TIPS to match their long-term liabilities with inflation-protected assets to make sure they have future cash flow.

Retirees and those focused on generating a stable income stream can benefit from TIPS. As we touched on earlier, the semi-annual interest payments adjusted for inflation provide a reliable income that keeps pace with the rising cost of living. In addition, TIPS can be great for those who may be saving for retirement. Long-term investors who are concerned about the impact of inflation over extended periods can leverage TIPS, though this investment strategy may be best for those who are convinced there will be a high rate of inflation for years to come. 

Investors who are sensitive to state and local taxes might find TIPS advantageous. As we talked about earlier, there are some local and state tax benefits to owning TIPS. Other forms of niche investors may actually be ESG investors. If an investor does not align with corporate ESG policies but instead politically aligns with the prevailing government entity legislation, they can choose to invest in fixed-income securities by entities (i.e. the government in this example) they align with regarding ESG. 

TIPS and Nominal Bonds

Let's quickly cover the difference between nominal bonds and TIPS. Nominal bonds and TIPS are both types of bonds issued by the U.S. Treasury, but they differ primarily in how they handle inflation protection. Nominal bonds, also known as conventional bonds, pay a fixed interest rate over the life of the bond, and the principal value remains constant until maturity. They do not provide explicit protection against inflation. TIPS, on the other hand, are specifically designed to protect investors from inflation. 

Nominal bonds pay fixed interest payments based on the face value of the bond. These coupon payments do not adjust for changes in inflation. The market price of these nominal bonds fluctuates based on interest rates and overall market considerations. The yield on nominal bonds is fixed. 

Interest income from both nominal bonds and TIPS is subject to federal income tax. However, the inflation adjustments to the principal of TIPS are also taxable as income in the year they occur. This is not the case for nominal bonds. 

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, fast-forward about five years to see the impact that inflation has had. According to TIPSWatch, on March 21, 2024, the first reopening auction for TIPS received a real yield to maturity of 1.932%.

Have Have TIPS Performed?

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.

In 2023, as inflation cooled and the Fed lowered interest rates, TIPS struggled to perform well. From January 1, 2023 to December 31, 2023, the iShares TIPS Bond ETF returned an annual return of 0.99%, gaining $1.05 over the course of the year. Most of this return had been given back through the first several months of 2024; from the start of the year to the end of Mary 2024, the ETF had a loss of 0.73%.

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.