Treasury inflation-protected securities, or "TIPS," are Treasury bonds that are indexed to inflation. However, these fixed-income investments do not work the same as conventional bonds. Often purchased in mutual funds, individual TIPS bonds can be an important portfolio component for investors who want to maintain the purchasing power of their savings.
But TIPS, despite being issued by the U.S. government, are not free of risk—particularly if you choose to access the asset class through mutual funds or exchange-traded funds (ETFs). Learn more about how TIPS work, as well as the benefits and drawbacks of investing in TIPS.
What Are Treasury Inflation-Protected Securities (TIPS)?
TIPS are Treasury bonds that 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 with TIPS goes up and down, because the principal is always being adjusted according to changes in the Consumer Price Index (CPI).
The Risks of Investing in Individual TIPS
TIPS can be stable investments because of their low relative market risk and low inflation risk. However, TIPS are not guaranteed investments and prices can fluctuate, similar to conventional bonds. Investors are wise to understand the primary benefits and risks involved.
Since TIPS are backed by the full faith and credit of the United States government, they are seen as being free of credit risk. In other words, investors are guaranteed to receive all of the interest and principal that’s coming to them.
While the price of a TIPS bond will fluctuate between the time when it is issued and the date at which it matures, a person who holds until maturity isn’t affected by these price movements. However, this moderate level of volatility does have the potential to become an issue if a person sells a bond prior to its maturity date. In this case, they aren't guaranteed to receive the bond’s par value since its market price could be more or less than par at the time of the sale.
Another potential risk of TIPS is that the official CPI fails to track actual inflation or the rising prices of the products or services the investor needs. In this case, there is the chance that the element of inflation protection in the bonds will be insufficient to protect that investor’s true purchasing power.
A third risk is the rare chance of deflation or falling prices. In this case, investors would likely sell TIPS—driving prices down—since there would be no need for inflation protection. This occurred during the depths of the financial crisis of 2008, when fears of a worldwide financial meltdown raised the possibility of deflation and led to a sharp decline in the prices of TIPS in the autumn of that year. Deflation is a long-shot possibility, but one that merits consideration.
The Risk of TIPS Mutual Funds and ETFs
While TIPS will work as intended for investors who buy individual bonds and hold them to maturity, those who hold TIPS via mutual funds or ETFs face an entirely different set of risks.
Funds do provide an element of inflation protection in the sense that the principal value of the bonds held by the funds will indeed adjust upward with inflation. However, unlike individual securities, bond funds have no maturity date. This means that investors are not guaranteed to see a full return of principal. And since TIPS are highly sensitive to interest rate movements, the value of a TIPS mutual fund or ETF can fluctuate widely in a very short period.
A prime example of this danger occurred in November and December of 2010. In that two-month period, bond yields spiked higher as prices fell, driving the yield on the 10-year U.S. Treasury note from 2.66% on Nov. 1 to 3.30% on December 31. In that same time period, the largest TIPS ETF, iShares Barclays TIPS Bond Fund (ticker: TIP) returned -3.8%. The fund was also hammered for a loss of 8.1% in May to June 2013 amid a similar spike in Treasury yields.
These losses are meaningful since inflation typically has run in the 1% to 3% range in recent years. As a result, it doesn't take much of a loss to offset the protection feature in the funds’ TIPS holdings.
Factors Influencing TIPS
To gain a greater understanding of TIPS, investors are wise to learn the factors that influence the price and yield of these fixed-income investment securities. If investors understand what influences TIPS, they may be better informed about the benefits and risks of holding these investments.
The primary factors influencing tips are interest rate changes and inflation expectations.
- 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.
- Inflation expectations: Changing expectations of future inflation are often the primary drivers of demand for TIPS. The spread between conventional U.S. Treasury bonds and TIPS can mostly be attributed to the expected inflation rate.
The Bottom Line
TIPS funds are a type of fixed-income investment, and as such, a TIPS fund can be a smart addition to a diversified portfolio, providing a positive inflation-adjusted return for long-term investors. That being said, investors should be aware that they do not work the same as mutual funds that invest in corporate bonds.
As mentioned, TIPS are not guaranteed investments. Although they are indexed to inflation, they are not guaranteed to increase in value during inflationary periods. TIPS respond more to expectations of investors, as opposed to actual movements of inflation.
For example, 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. TIPs should not be viewed as a “be all” alternative to broad bond diversification, and investors should use other types of bond funds as well.
Frequently Asked Questions (FAQs)
How are Treasury inflation-protected securities taxed?
Any interest and gains earned on TIPS are subject to federal income taxes. However, TIPS are exempt from state and local income taxes.
When is a good time to invest in TIPS?
TIPS can be a good investment choice when inflation is running high, since they adjust payments when interest rates rise, whereas other bonds don't. This is usually a good strategy for short-term investing, but stocks and other investments may offer better long-term returns.