Treasury inflation-protected securities, aka 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, TIPS can provide investors a degree of protection against inflation. Investors are wise to learn the benefits and risks 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 goes up and down because the principal is always being adjusted according to changes in the Consumer Price Index (CPI).
The Benefits and Risks of TIPS
TIPS and mutual funds that invest in TIPS can be stable investments because their low relative market 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 of TIPS and TIPS mutual funds.
Here are the benefits of TIPS:
- Low market risk: TIPS are low-risk investments because they're Treasury bonds, backed by the U.S. government.
- Low inflation risk: TIPS are indexed for inflation so there's almost no inflation risk as long as your personal rate of inflation is close to the CPI rate.
Here are the risks of TIPS:
- Price fluctuation: Although TIPS are low-risk investments, their market prices can 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, deflation, is the opposite of inflation. If there were to be a long period of deflation, TIPS would potentially lose some value.
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. 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.
Common Misconceptions of TIPS
Although TIPS and other fixed-income investments work similarly to conventional bonds, investors should understand that TIPS are not guaranteed investments. Although TIPS 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.
The Bottom Line
A TIPS fund can be a smart addition to a diversified portfolio, providing a positive inflation-adjusted return for long-term investors. TIPS funds are a type of fixed-income investment; however, investors should be aware that they do not work the same as mutual funds that invest in corporate bonds. They 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 earned on TIPS is subject to federal income taxes. However, growth on 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 offer guaranteed protection where other securities may not. This is usually a good strategy for short-term investing, while stocks and other bonds offer better long-range returns.
How do I buy Treasury inflation-protected securities?
You can purchase TIPS directly through the U.S. Treasury with an account at TreasuryDirect. If you'd prefer to buy them in person, you can get your TIPS through a bank or broker.