Key points
- TIPS are government bonds indexed to inflation.
- The principal of TIPS increases with inflation and decreases with deflation.
- If you hold TIPS to maturity, you will receive at least the original principal.
Inflation is like the Cookie Monster in your portfolio, eating more and more and more. The longer you invest, the greater the potential impact on your overall returns. That is especially true of fixed-income investments, where the purchasing power of your regular interest rates declines as inflation climbs.
With inflation reaching its highest levels since the 1980s in recent years, many investors are seeking places to shelter their money. One such place is in Treasury inflation-protected securities.
What are TIPS?
TIPS are a type of Treasury security whose principal is adjusted for inflation.
When inflation as measured by the consumer price index for all urban consumers increases, the principal increases. TIPS pay interest every six months, meaning you get larger interest payments during periods of inflation.
The reverse is true during deflationary periods. The principal decreases as inflation decreases, along with your semiannual interest payment.
At maturity, you always get back at least what you paid. If the principal is equal to or lower than your original investment, you get your original investment. If the principal is higher than your original investment, you get the higher amount.
This return of principal is guaranteed only if you hold the TIPS to maturity. While TIPS can be sold on the secondary market, there is no guarantee you will recoup your original investment.
How to invest in TIPS
TIPS are available with five-, 10- and 30-year maturities. They can be purchased in increments of $100.
You can buy individual TIPS directly from the U.S. government at TreasuryDirect.gov or through a brokerage firm. Or you can buy a basket of TIPS by using a mutual fund or an exchange-traded fund.
TIPS mutual funds include the Fidelity Inflation-Protected Bond Index Fund (FIPDX), Vanguard Inflation-Protected Securities Fund Investor Shares (VIPSX) and Schwab Treasury Inflation Protected Securities Index Fund (SWRSX).
TIPS ETFs include the iShares 0-5 Year TIPS Bond ETF (STIP), Schwab U.S. TIPS ETF (SCHP) and Vanguard Short-Term Inflation-Protected Securities ETF (VTIP).
“For simplicity’s sake and diversification, it may be best to buy a managed ETF for most investors,” said Daniel Milan, managing partner and investment advisor representative at Cornerstone Financial Services.
The other benefit of a TIPS mutual fund or ETF is you may be able to purchase the fund in smaller increments than the Treasury’s $100 minimum.
As with any mutual fund or ETF investment, pay attention to the expense ratio, track record and size. You want a fund with enough assets and trading volume that it’s easy for you to buy and sell when you want to but a low enough expense ratio that you don’t lose the inflation-protection benefit to management fees.
TIPS vs. other Treasury investments
Like other Treasury investments, TIPS are backed by the full faith and credit of the U.S. government, making them a relatively safe investment option.
But U.S. government securities aren’t risk-free. In fact, Fitch Ratings recently downgraded its U.S. credit rating from AAA to AA+.
“The rating downgrade of the United States reflects the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to ‘AA’ and ‘AAA’ rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions,” the credit rating agency wrote in a press release on Aug. 1.
The U.S. government maintains a top Aaa rating from Moody’s and a second-tier AA+ rating from Standard & Poor’s.
“TIPS are different from other Treasury securities in that they are meant to protect against rising inflation and thus mitigate inflation eroding the value of the bond and cash flow as inflation increases over the lifetime of the bond,” Milan said.
TIPS were first auctioned in January 1997 due to investor interest in inflation-indexed assets. They were originally available in only 10-year terms, with other maturities added over the next several years.
Pros and cons of investing in TIPS
When inflation surges, it’s easy to see the benefit of TIPS. But TIPS also have drawbacks relative to other fixed-income securities. As an investor, you should weigh the pros and cons of any investment before deciding how to allocate your money.
Pros
- Inflation protection. TIPS provide protection from inflation by adjusting the principal relative to the CPI-U.
- Principal protection. At maturity, you get back at least the original principal.
- Regular interest. TIPS pay interest every six months, so you can count on regular income from these securities. But remember that the interest payment varies.
- Relative safety. As U.S. government-backed securities, TIPS are among the safest investment options.
Cons
- Lower interest rate. TIPS often pay lower interest rates than other Treasury securities. For example, a 10-year TIPS with an original auction date of July 20 had a rate of 1.375%, while a 10-year Treasury note issued on Aug. 15 had a rate of 3.875%.
- Potential loss if not held to maturity. You are guaranteed the return of your principal only if you hold the TIPS to maturity. If you sell before then on the secondary market, you could receive less.
- Reduced interest due to deflation. Since the principal is reduced during periods of deflation, you may receive lower interest payments when inflation declines.
- Interest rate risk. Interest rate increases can cause the value of TIPS to decline. Thus far in 2023, the average TIPS fund is up only 1.6%, compared to 12.1% for the overall bond market.
Should you invest in TIPS?
Given the pros and cons, the question of whether you should invest in TIPS remains.
“There is a strong utility case for TIPS in certain inflationary markets,” Milan said. “But investors should remember that they are not a pure inflation hedge.” TIPS, like other bonds, are subject to interest rate risk. When interest rates increase to combat inflation, the market value of TIPS is likely to plummet.
In deflationary periods, lower interest rates may reduce long-term TIPS returns, meaning you may be better off with a Treasury security whose principal doesn’t decrease in value.
TIPS may not be the best fixed-income investment if you’re looking to reduce volatility. They can be more sensitive to interest rate fluctuations than other fixed-income securities because of the mercurial nature of their principal.
“I believe with the Federal Reserve rapidly adjusting interest rates, the impact on inflation will give TIPS much more of a roller coaster ride than expected,” said Rob Burnette, CEO and investment advisor representative at Outlook Financial Center.
So if you decide to invest, remember that TIPS aren’t always a good short-term hedge against inflation. Their returns may not match those of other bond funds. But they should at least keep pace with inflation over the long term.
Frequently asked questions (FAQs)
TIPS are backed by the full faith and credit of the U.S. government, making them a relatively safe investment option. They are subject to interest rate risk, however, and you may not get the original principal back if you sell them before maturity.
TIPS are worth investing in if you’re concerned about inflation and want a relatively stable place to keep your cash. But they tend to have lower interest rates than other fixed-income securities, so they are not ideal for long-term growth.
The best time to buy TIPS is when you expect inflation to increase. Since the principal on TIPS is adjusted upward for inflation, you’ll receive a higher return than you may with other securities. This adjustability can make TIPS prices volatile. In 2022, the average TIPS fund lost 9.5%. But price drops can be the best time to buy TIPS.
