What Is An Inflation Protected Bond?

Here's how inflation protected bonds work.

Inflation Protected Bonds
Do you need inflation protected bonds as part of your portfolio?. GSO Images

Inflation-protected bonds, also known as TIPS (which stands for Treasury Inflation-Protected Securities) are issued by the U.S. Government. The payouts on this type of bond increase with inflation. Which means you can get more income in times of high inflation. Here's how they work.

How Does a TIP Protect You From Inflation?

Interest paid on a TIP is based on a rate that is multiplied by the principal value of the bond.

The principal value of an inflation-protected bond is adjusted upward or downward based on changes in the Consumer Price Index, which is the formal measure of inflation in the United States.

Inflation protected bonds pay a fixed rate of interest twice a year. If the principal is adjusted up due to inflation then the fixed interest rate will be applied to the new higher principal amount, and so a higher dollar amount of interest will be paid out. This means if you own an inflation protected bond, and there is inflation, you will see an increase in the interest income you receive from the bond.

How Does an Inflation Protected Bond Fund Work?

Inflation protected bonds funds buy and sell TIPS for you, collect the interest, and pay it out to you. A fund manager is deciding which bonds to purchase or sell. Funds make a convenient alternative to buying individual bonds on your own.

The interest paid out on these bonds is taxable income to you.

For this reason, most people will want to own this type of investment in a retirement account where all the interest accumulates tax-deferred.

If you want to own inflation protected bonds with your regular savings, check out I-Bonds for a more tax efficient alternative.

Where Can I Buy Inflation Protected Bonds or Funds?

You can buy inflation protected bonds directly from the U.S. Treasury by opening your own account through Treasury Direct.

I tried Treasury Direct once and found the system cumbersome and inconvenient to use. You can also buy TIPS through most brokers, although an additional fee may be charged by the brokerage firm or broker. The fee may be worth the convenience of having an easily accessible account.

As far as funds go, you can purchase those through just about any broker or online account. Check out US News & World Report's inflation protected bond fund list to get an idea of the types of funds that are out there.

Do You Need Inflation Protected Bonds?

Research on retiree spending patterns suggests that once retired, your spending will not steadily rise with the pace of inflation. Retirees often spend more in their early retirement years, but then spending tends to taper off with aging as you travel and go out less. This means contrary to what many believe, you may not need to worry about inflation in retirement as much as previously thought.

In 2008/2009 when the Fed started a looser money policy, there was a huge concern that the result would be super high inflation rates, but wild inflation has not ensued. As a matter of fact, inflation rates have remained quite tame.

One of the best sources of inflation-protected income is Social Security, as benefits are adjusted upward based on changes in the consumer price index.

The appropriate allocation to equities can also make a good inflation hedge. Gold is actually not such a great inflation hedge, and it produces no income or dividends, so I prefer people to allocate to stocks to hedge inflation rather than allocate to gold.

Another tool you have against inflation is to manage expenses into "must haves" and "like-to-haves". If inflation rates soar, you can start giving up some of the "like-to-haves". In the long run this approach may work far better for you than allocating too much of your portfolio toward hedging something that may not end up being a problem.