Pros and Cons of TIPS Mutual Funds

Are TIPS Mutual Funds for You?

investment portfolio and chart on computer screen
•••

 

Rafe Swan / Getty Images

TIPS mutual funds invest in Treasury inflation-protected securities, also known as TIPS. The main advantage of a TIPS fund is that it can increase in value during periods of rising inflation. Therefore, TIPS funds can help you fight inflation and receive greater returns than a broad market bond index fund.

Learn more about TIPS mutual funds and how they can help you during times when inflation is rising.

Key Takeaways

  • TIPS mutual funds invest in Treasury inflation-protected securities (TIPS).
  • One major advantage of investing in TIPS funds is that they may increase in value during inflationary periods.
  • Other pros of TIPS funds are skilled management, diversification, convenience, and automatic reinvestment.
  • Cons of TIPS funds are volatility and the fees associated with them.

What Are TIPS?

TIPS are bonds issued by the U.S. Treasury that pay a coupon on the adjusted value of the bond. The bond is adjusted every six months with the rate of the Consumer Price Index (used to measure the rate of inflation). So, TIPS are said to keep pace with inflation by giving the owner coupon payments; they also give them an adjusted value when the asset matures.

The primary advantage of investing in TIPS funds is that they may increase in value during inflationary periods. In contrast, conventional bond funds may decline in value in the same environment. You can invest in Treasury Inflation-Protected Securities through mutual funds and enjoy many of the advantages.

Pros and Cons of TIPS

Pros
  • Professional management

  • Diversification

  • Convenience

  • Reinvestment

  • Value increase

Cons
  • Volatility

  • Fees

  • Interest payments based on inflation

Pros Explained

  • Professional Management: Fund managers will add value by looking for under-priced TIPS in other markets.
  • Diversification: TIPS with varying maturities will be owned by a TIPS fund giving you more diversity.
  • Convenience: Unlike buying a TIPS, a TIPS fund can be bought and sold in odd dollar amounts. You won't need to roll a TIP upon maturity; the fund's staff will ensure there more TIPS added to the fund.
  • Reinvestment: Unlike TIPS bonds, income from TIPS funds can be reinvested in the fund without a sales charge.
  • Value increase: The value of TIPS funds can increase when other fixed-income funds are losing value, such as when interest rates are raised.

Cons Explained

  • Volatility: Unlike TIPS bonds, TIPS mutual funds do not have a maturity, so if you want to cash out, you must accept the current price. That price might be higher or lower than the amount you invested.
  • Fees: There are more fees when you buy into a TIPS mutual fund, making them a little more costly than TIPS bonds.
  • Interest payments: TIPS pay interest twice per year. However, the interest payments are based on the inflation-adjusted value, so they are not set. This makes it hard to predict payments if you're using them for a retirement income strategy.

Tax Tips on TIPS Mutual Funds

If you own TIPS mutual funds, you're taxed on both the annual income and the amount of the adjusted value. The tax on the adjustment is called “phantom income,” because you don't actually receive the adjustment in the form of an interest payment or dividend.

Many TIPS mutual funds will pay out the adjusted portion as a dividend. If you reinvest the dividends, you still owe income tax on it. For this reason, many investors wisely choose to hold TIPS in a tax-deferred retirement account like an IRA to avoid taxes.

Bottom Line

Buying a TIPS mutual fund will not protect your money in the way a TIPS does. In the short term, TIPS funds may be risky than TIPS. TIPS are priced daily based on a view of future inflation rates. Their value is also affected by changes in interest rates. If you own the TIPS outright, you will receive your adjusted principal upon maturity.

However, unlike a TIPS, a TIPS mutual fund does not mature. There is no guarantee that you will receive all of your money back when you withdraw it. Unless you are a speculator, you should buy TIPS mutual funds for the inflation protection they provide. When you buy into funds, ensure that you use them in the fixed-income portion of your portfolio.