Inflation is soaring, and that creates problems for investors. Stock markets are performing poorly, and even with rising interest rates, it’s hard to find fixed-income alternatives that yield more than the inflation rate. Treasury Inflation-Protected Securities, or TIPS, provide a way for investors to offset inflation with a relatively secure financial instrument.
What Are TIPS?
Like I-bonds and other Treasury bonds, TIPS are issued and backed by the U.S. government. This offers a level of security and comfort you won’t get with corporate bonds, stocks, or exchange-traded funds.
Most government bonds have fluctuating, unpredictable yields and prices based on a multitude of factors, including supply and demand in the bond market. There’s typically little or no adjustment made for elevated inflation, and they might not offer much protection for frustrated investors.
If the yield on your bond is lower than the inflation rate, you are actually losing money. That is not an appealing prospect.
In contrast, TIPS are specifically designed to be inflation-linked. The U.S. Treasury adjusts the principal of a TIPS using the most commonly known measure of annualized inflation, the Consumer Price Index or CPI, which is released monthly by the Bureau of Labor Statistics.
Plus, the Treasury assures that, upon maturity, a TIPS holder will get either the inflation-adjusted price of the TIPS or the original principal, whichever is greater. Hence, you’ll never get a penny less than the original principal you invested in the TIPS.
Moreover, with a TIPS, you’ll get a fixed interest rate, which is set at an auction and won’t change after that, and the rate is never less than 0.125%. That’s a feature you won’t typically get with bonds in general and certainly won’t get with riskier assets.
📅 As of Dec. 13, 2022, the TIPS yield is 1.324%. That may not sound like much, but remember that this is on top of your inflation protection.
👉 For Example
An investor holds $5000 in TIPS with a coupon rate of 1% for a year in which the Consumer Price Index (CPI) rises 6%. The interest for the year will be $50, and the principal amount of the bond will be adjusted upwards to $5300.
In effect, the investor has gained $350, or 7%. The next year’s interest will be based on the increased principal.
Are TIPS the Same Thing as I-Bonds?
The Treasury makes it crystal clear that, while there are some similarities between a TIPS and a Series I Savings Bond (also known as an I-Bond), there’s definitely not the same thing. For one thing, I-Bonds are non-marketable, which means they cannot be bought or sold in a secondary securities market.
☝️ I Bonds offer a valuable hedge against inflation but are not for every investor. Consider these pros and cons of I Bonds before investing.
People don’t typically buy TIPS to “flip” them for short-term gains, but at least you’ll know that you can buy and sell them in a secondary securities market (with the proviso that TIPS can’t be sold in a secondary market until they mature).
Then, of course, there’s the strong inflation-adjustment focus of TIPS which isn’t quite as present with I-Bonds. With a TIPS, there’s the inflation-adjusted principal that’s used to calculate the interest the holder will receive.
These are semiannual (twice per year) interest payments, as opposed to I-Bonds, where interest accumulates over the life of the I-Bond and is only paid to the holder upon redemption.
There is some inflation indexing with both TIPS and I-Bonds. Here’s the difference, though: I-bonds are indexed to a semiannual inflation rate that’s announced in May and November. Meanwhile, TIPS are inflation-indexed every single month of the year, as that’s how often the Labor Department’s CPI report is released.
There’s also a difference in the time frame/maturity duration between a TIPS and an I-Bond. Whereas I-Bonds are rather inflexible – they always have a 30-year life span – a TIPS gives you time-horizon choices with life spans of 5, 10, and 30 years.
Why Should I Buy TIPS?
TIPS provides the assurance and risk control that many other government bonds do, including I-Bonds. Yet, most government bonds don’t actually increase your principal when the CPI rises or make monthly inflation-based adjustments. A TIPS does.
Frankly, TIPS are among the most underappreciated government-backed assets. They rarely get attention in the financial press, though with inflation rearing its ugly head in 2022 and 2023, the appeal of TIPS is readily apparent.
Again, there’s also the flexibility aspect of TIPS, which offers three different maturity durations.
👉 Portfolios of practically all sizes can accommodate a TIPS as the minimum purchase amount from the Treasury is $100; above and beyond that, TIPS purchases are made in increments of $100.
There may also be favorable tax treatment with TIPS. Specifically, there are no state or local taxes applied to a TIPS (that’s according to the U.S. Treasury, but be sure to double-check this with a licensed tax professional).
⚠️ Be aware, however, that you’ll be expected to pay federal tax each year on any interest earned from a TIPS. Also, your federal taxes might be affected by any increase or decrease in the principal of your TIPS.
Yet another reason to buy TIPS is that you’ll get instant portfolio diversification, but with a special inflation-adjustment angle that few other financial instruments can offer. This isn’t to suggest that anyone ought to renounce cash completely. It’s an interesting idea, though, to exchange some excess cash for TIPS during times of high inflation – like 2022 and 2023, for instance. Just bear in mind that a TIPS isn’t quite as liquid as cash, so know your time horizon before investing in one.
Where Can I Buy TIPS?
If you have a portfolio manager at a bank, he or she can probably help you invest in TIPS. You could also try delving into a secondary securities market to purchase TIPS, though that’s generally only recommended for advanced traders.
If you’re a do-it-yourself type of investor, you can purchase TIPS directly through the U.S. Treasury’s website known as TreasuryDirect.gov. That way, you’ll be buying right from the source and eliminating the middleman (such as a bank, broker, or dealer).
Ultimately, there’s no need to seek out complex financial instruments or high-risk assets when you can easily purchase a government-issued bond that’s designed to help you deal with lofty inflation. So, feel free to diversify your portfolio with ease and flexibility – take a tip from me and give TIPS a try today.
