What Are Treasury Inflation Protected Securities?

TIPS are Treasury bonds that protects you from rising prices. Photo: Tetra Images/Getty Images

Definition: Treasury Inflated Protected Securities are bonds that protect you from inflation. They are offered by the U.S. Treasury Department of the federal government. Despite their benefits, these bonds may not be a good investment most of the time.

How They Work

TIPS are issued in terms of five, 10 and 30 years. Like other Treasury bonds, an auction determines the interest rate.

Here's how these bonds protect you from inflation.

Twice a year, the U.S. Treasury Department raises or lowers the bond's value. It bases the increase on price changes reported by the Consumer Price Index. This report, published monthly by the Bureau of Labor Statistics, measures inflation or deflation. When inflation rises, the value of the bond also increases.

Keep in mind that the interest rate does not change. But you receive a bigger payment. That's because the fixed interest rate is applied to the larger principal.

The opposite is true in times of deflation. If prices drop, as measured by the CPI, the value of TIPS will also decline. Now the fixed interest rate is being applied to a lower principal.

You can buy TIPS directly from the U.S. Treasury if you open a TreasuryDirect account. You can hold TIPS until they mature. You can also sell them on the secondary market. You may think of selling if you see deflation looming on the horizon.

Advantages of TIPS

As you would expect, TIPS do well during inflation, or even if inflation is expected. People on the secondary market pay a lot more for the safety of TIPS if they are afraid of inflation. For this reason, TIPS also do well when the value of the dollar is declining. That's because a declining dollar usually leads to inflation.

That’s because import prices rise as the dollar buys less.

Here's a nice benefit of TIPS. When they mature, you receive the highest adjusted principal. You will never receive less than the original principal. This provision protects you against deflation, because you'll never receive less even if prices drop.

For example, if there's a double-digit inflation sometime during the duration of the TIPS, its value rises. When the TIPS mature, you receive that value. This holds true even if deflation has chipped away at the principal in subsequent years.

The other benefit is that you will never lose your principal. TIPS, like all Treasury bonds, are 100 percent guaranteed by the U.S. government.

Disadvantages of TIPS

The first piece of bad news is that TIPS only pay you a fixed rate of interest. They may not be as good an investment as those bonds with adjustable interest rates that automatically rise and fall with the federal funds rate. That’s especially true now as the federal government contemplates raising interest rates. Even though the fixed rate can be applied to a higher principal, TIPS isn't as flexible as bonds with an adjustable rate.

TIPS aren't a great investment during a stable economy.

They will return the flat interest rate on a flat principal when the economy is doing well, and therefore not experiencing much inflation.This state describes the U.S. economy since the 1970s.That's the last time double-digit inflation existed.

If you want to beat inflation, you'd be better off with a well-diversified portfolio that includes stocks. That way, you can adjust your asset allocation in keeping with the changes in the business cycle. For more ideas, see How Can I Protect Myself from Inflation?

TIPS versus I Bonds

I bonds are Series I savings bonds, while TIPS are Treasury bonds. This means I bonds cannot be traded on the secondary market. I bonds can be bought with as little as $25 if purchased electronically via TreasuryDirect. You will never lose your principal. The interest earned is exempt from state and local income tax.

You still have to pay federal income taxes, though, unless you use the bonds to pay for education.

One disadvantage with I bonds is that you don't receive any interest payments until you redeem the bond. Your money is also tied up for at least a year. The I bond is meant to be a long-term investment. The U.S. Treasury won't allow you to redeem it for at least 12 months. There is a penalty if you redeem your I bond in less than five years. The penalty is mild, though. It's only the interest earned in the previous three months.

Another important difference is how they protect you from inflation. The interest rate on the I bond automatically adjusts for price increases. How does it work? First, you are guaranteed a fixed rate of return that doesn't change. Second, the rate will increase if there is inflation. This may occur twice a year on May and November.  But it won't decrease if there is deflation. In May, the rate will reflect the change in the CPI for all Urban Consumers from September of the prior year to March. In November, the rate will reflect the change in the CPI-U from March to September.

The easiest way to buy I bonds is through online purchasing from the U.S. government via Treasury Direct. It is all electronic, so you don't have to worry about losing the bonds. You can also buy paper I bonds from your bank or financial planner. Whatever you do, don't buy an I bond or any other U.S. Treasury bond on eBay or other third party. The ownership of these bonds is still the original owner, as far as the federal government is concerned. The owner cannot sell his or her rights to the bond to you. All you are buying is a piece of paper that you cannot redeem. (Source: “TIPS versus I Bonds”)