The Benefits and Risks of TIPS—Treasury Inflation Protected Securities
Like all investments, TIPS have both pros and cons
Investors should always be aware of the benefits and risks of any vehicle into which they're considering putting their money. It's no different with TIPS, shorthand for "treasury inflation protected securities."
The Benefits and Risks of TIPS
TIPS are designed to preserve purchasing power in the long run by protecting investors against the risk of inflation. They're bonds issued by the U.S. Treasury that have a fixed rate of interest. The dollar amount of the interest payment goes up and down because the principal is always being adjusted according to changes in the Consumer Price Index or CPI. The U.S. Treasury pays either the original or adjusted principal when these securities mature, whichever is greater.
TIPS present virtually no default risk because they're treasury bonds. And they're indexed for inflation so there's almost no inflation risk as long as your personal rate of inflation is close to the CPI rate. But they’re not risk-free. TIPS market prices move substantially with changes in real interest rates. That means that the share price of a mutual fund investing in TIPS can vary significantly over the short term.
Deflation risk—the risk of a general decline in prices, which is the opposite of inflation—is another consideration. If there were to be a long period of deflation, TIPS would potentially lose some value. However, the U.S. Treasury has pledged to pay any investor in TIPS one hundred cents on the dollar of the principal value.
Factors Influencing TIPS
Interest Rate Changes:
- TIPS prices respond to changes in interest rates, similar to other bonds.
- Conventional bonds have the expectation for future inflation rates built into their yields.
- TIPS respond to changes in the “real” interest rates—current interest rates minus inflation rates.
- Changing expectations of future inflation are often the primary drivers of demand for TIPS.
- Conventional bonds have the expectations for future inflation rates built into their yields.
- The spread between conventional U.S. Treasury bonds and TIPS can mostly be attributed to the expected inflation rate. When actual inflation is higher than expected, TIPS will likely outperform conventional bonds, and if actual inflation is lower than expected, TIPS will likely underperform conventional bonds.
The Bottom Line: Who Should Invest in a TIPS Fund?
A TIPS fund can play an important role in a diversified portfolio, providing a positive inflation-adjusted return for long-term investors. A TIPS fund is meant to further diversify a well-established, broadly diversified investment portfolio. It should not be viewed as a “be all” alternative to broad bond diversification and investors should use other types of bond funds as well.
A TIPS fund is not suitable for investors unwilling to tolerate moderate fluctuations in share price, or those seeking long-term capital growth.
John Hollyer, co-manager of the Vanguard Inflation-Protected Securities Fund, was kind enough to answer several of these questions regarding the benefits and risks of TIPS. This article is an executive summary of the entire interview and has been provided by Vanguard.
Note: Always consult with a financial professional for the most up-to-date information and trends. This article is not investment advice and it is not intended as investment advice.