Treasury Inflation-Protected Securities have had a rough year. Their price declines have far outpaced the upward principal adjustment they automatically get from inflation. Indeed, for the 12-month period through the end of September, these government securities have booked their worst performance ever. However, their prospects are beginning to look compelling again. Consider working with a financial advisor as you consider your choices of various fixed-income securities and which ones offer you tax efficiency.
What Are TIPS?
Treasury Inflation-Protected Securities (TIPS), which come in 5-, 10- or 30-year terms, are a type of fixed-income security that the United States Treasury issues on a regular basis. As such they are seen as low-risk securities that pay out interest twice a year until their term expires, that is, when the bond reaches maturity.
While a standard Treasury bill, note or bond will keep the same principal throughout its term, the par value of a TIPS will increase in line with the Consumer Price Index (CPI). This is intended to keep the principal of the bond on track with inflation. When a TIPS matures, its owner gets either the principal that has been adjusted higher or the original principal value. In other words, at maturity the principal value of a TIPS cannot be less than the initial principal value.
A second benefit of TIPS stems from its coupon payments. These are based on a percent of the adjusted principal, so investors can also benefit from higher income payments when inflation is rising.
In other words, if inflation spikes in a given year, your investment’s principal will adjust upwardly in value during that year. So, instead of having a bond that’s worth relatively less once it matures, you have a bond that maintains its principal value throughout its life.
How TIPS Work
To purchase TIPS, you have several options. You can purchase newly issued TIPS directly from the U.S. Treasury if you have a TreasuryDirect account. This is typically the cheapest option. If you’d rather not go through the process yourself, you can also purchase TIPS from a bank or investment broker.
To break down how TIPS work, let’s consider an example. Let’s say you purchase a TIPS with a par value of $1,000 and an interest rate of 0.3%. After one year, the Consumer Price Index has risen 4%, which means the par value of your bond is now $1,040. So instead of receiving $3 in interest, your investment has risen a total of $43.12.
Why TIPS Have Posted Negative Total Returns
The market has not been kind to TIPS this year. Charles Schwab, citing Bloomberg data, notes that the average price of the TIPS index has dropped by more than 19% in 2022. The key is rising interest rates. Since bond prices and yields move in opposite directions, this year’s jump in interest rates, which drives down bond prices, has offset the upward inflation adjustment of TIPS’ principal value. The upshot has been a negative total return.
When buying or selling TIPS on the secondary market, keep in mind that the price does not include the adjusted principal value.
“The Bloomberg U.S. TIPS Index is down 13% this year through October 18th, while the Bloomberg U.S. Treasury Index is down a bit more, with a negative 14% total return over the same period,” Schwab said. “So even though the Consumer Price Index (CPI) is up 8.2% in the 12 months ending September 31, 2022, the price decline more than offset that positive principal adjustment.”
What to Do About It
For openers, don’t give up on TIPS for inflation protection. Despite the way rising interest rates in 2022 have slashed the price of TIPS so much that they offset the upward adjustment of the principal value for inflation, these remain compelling long-term investments. “With real yields well above zero, investors can finally earn higher income with TIPS while also helping protect against inflation over the long run,” Schwab says.
For another thing, retail investors who hold TIPS in mutual funds or exchange-traded funds should not panic. The brokerage says that if yields rise and the funds rebalance, investors reap higher income payments to help offset some potential price declines, while additional increases would result in positive principal adjustments to the underlying holdings.
Bottom Line
The total return of a TIPS investment depends on inflation and interest rates. Provided interest rates don’t rise very much, as they have been lately, these securities usually deliver inflation protection. As interest rate hikes by the Federal Reserve ease, the historic value of TIPS investments as inflation protection should return to normal. To adapt a common phrase, past negative performance is no guarantee of future negative performance.
Tips on Bond Investing
- The insight and guidance of a financial advisor can help you with the fixed-income portion of your portfolio in a tax-efficient manner. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Use our free inflation calculator as you seek an estimate of how inflation will affect your investments.
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