One downside of many low-risk investment products is that the rate of return often does not keep pace with inflation. That downside is eliminated with Treasury Inflation-Protected Securities (TIPS). With TIPS, your investment principal increases alongside the Consumer Price Index (CPI). TIPS makes it possible to invest with low risk without worrying about inflation erasing most or all of your return. A financial advisor can help you invest in TIPS and ensure your portfolio includes other inflation hedges.
What are Treasury Inflation-Protected Securities (TIPS)?
Treasury Inflation-Protected Securities (TIPS) are a type of fixed-income security that the United States Treasury issues on a regular basis. Fixed-income investments are investment products that are typically low-risk and pay out interest at fixed amounts until their maturity.
TIPS are very similar to a conventional Treasury bond, but there’s one key difference. While a standard Treasury 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.
In other words, if inflation spikes in a given year, as it did in 2021 and 2022, your investment will increase 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 value throughout its life.
How TIPS work
TIPS typically come in 5-, 10- or 30-year terms. Just like conventional treasury bonds, you will receive interest payments twice a year. 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.
The principal value of TIPS increases with inflation as measured by the Consumer Price Index (CPI), ensuring that the bond’s purchasing power is maintained over time. Twice a year, TIPS pay interest at a fixed rate, which is applied to the adjusted principal. As a result, the interest payments rise when inflation occurs, because they are based on the higher principal value. When the bond matures, investors are paid the greater of the original principal or the inflation-adjusted principal, ensuring protection against deflation as well.
To break down how TIPS works, 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.
Pros and Cons of TIPS
Treasury Inflation-Protected Securities (TIPS) are U.S. Treasury bonds designed to protect investors from inflation by adjusting their principal value based on changes in the Consumer Price Index (CPI). This inflation protection ensures that the purchasing power of the investment is preserved, making TIPS an attractive option for conservative investors.
They offer low risk, as they are backed by the U.S. government, and provide predictable real returns by paying a fixed interest rate on the inflation-adjusted principal. TIPS also contribute to portfolio diversification, as their performance does not directly correlate with stocks or conventional bonds.
However, TIPS have notable drawbacks. Their real yields are often lower than traditional Treasury bonds or other fixed-income securities, particularly in low-inflation environments. They are also subject to interest rate risk, where rising rates can decrease their market value. Additionally, TIPS creates a potential tax burden because the inflation adjustments to the principal are taxable in the year they occur, even though investors only receive the adjusted principal upon maturity.
This “phantom income” can complicate tax planning unless TIPS are held in tax-advantaged accounts. Furthermore, TIPS can decrease in value during periods of deflation, and their lower liquidity compared to other Treasury securities can result in higher transaction costs.
Overall, TIPS are most suitable for investors seeking inflation protection, especially those with access to tax-advantaged accounts to mitigate tax complexities. They can serve as a valuable tool for conservative investors looking to preserve purchasing power and diversify their portfolios. However, for those prioritizing higher nominal returns or operating in a low-inflation environment, TIPS may not be the best choice due to their lower yields and tax implications. Weighing these pros and cons can help determine if TIPS aligns with your financial goals and risk tolerance.
TIPS vs. Other Fixed-Income Securities
The biggest difference between TIPS and other fixed-income products (for instance, Treasury bills and corporate bonds) is the protection against inflation that TIPS provides. Rather than guaranteeing an increased par value, many traditional fixed-income investments use expected inflation to influence the offered interest rate.
In other words, if bond issuers expect a lot of inflation in the future, they may offer a higher interest rate than they otherwise would have to keep the bond attractive to purchasers. If inflation then turns out to be lower, purchasers of that bond enjoy a larger real interest rate (interest rate minus inflation rate).
So in terms of the real return you can expect, TIPS offers a higher floor and lower ceiling. On the other hand, many other more conventional bonds offer a lower floor but a higher ceiling. This is intuitive, as TIPS are an extremely low-risk investment, even in the realm of fixed income.
Bottom Line
If you are seeking low-risk investment options to help balance and stabilize your portfolio, Treasury Inflation-Protected Securities can be an excellent choice to consider. These government-backed securities are specifically designed to protect your investment against inflation, ensuring that your purchasing power is preserved over time. While no investment is completely free of downsides, TIPS offers a level of security that can make it an attractive option, particularly for investors looking to hedge against more volatile or higher-risk investments.
Tips for Smart Investing
- To build a well-balanced portfolio in line with your goals and risk tolerance, consider working with a financial advisor. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Prefer to do it yourself? Step one is determining your asset allocation, a key element for investors when it comes to balancing the risk of their portfolios. Investors with ample disposable income might choose a riskier asset allocation. Someone nearing retirement age, however, may want to be more conservative. SmartAsset’s asset allocation calculator can help you figure out the allocation that makes the most sense for you.
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