Treasury Inflation Protected Securities

What are TIPS?

Treasury Inflation Protected Securities, or TIPS, are government securities designed by the U.S. Treasury to help protect investors from inflation.

TIPS pay interest twice a year, at a fixed rate (not a fixed amount). The fixed rate is applied to the inflation/deflation adjusted principal. Therefore, the interest payments rise with inflation and fall with deflation. Both the interest and the principal payments are indexed against the Consumer Price Index. So the yield quoted on a TIPS is a "real" return -- that is, an incremental return that is added to the rate of inflation.

If inflation occurs while you hold TIPS, each interest payment will be higher than the last. If deflation occurs, each interest payment will be lower than the last. At maturity, the principal payment will not be less than par, but could be more than par if net inflation occurred during the life of the bond.

Both the interest earned as well as any increase in principal value on a TIPS are taxable at the Federal level. Since the increase in principal value is non-cash income, TIPS are best held in tax deferred or tax-free accounts.

If you would rather not buy TIPS yourself or do not want to manage them, there are several low expense mutual funds and ETFs that invest in TIPS. Check out our TIPS Investments.

Inflation and Taxes

Inflation is an economic term for increases in the cost of consumer goods and services over time. Because the cost of goods is steadily rising, investment returns must be adjusted for inflation, which means the only returns that help investors increase their purchasing power are “real” returns—or those returns left over after subtracting inflation. Therefore, choosing investments that will earn a return above the rate of inflation can protect an investor’s future purchasing power.

Taxes must also be considered as it is not what you make it is what you keep.

How high is the inflation hurdle? Over the last decade, inflation has averaged about 2.5% annually, based on year-over-year changes in the consumer price index (CPI). At a 2.5% inflation rate, goods and services that cost $100 a decade ago would cost about $128 today.

Source:
U.S. Bureau of Labor Statistics

More recently, inflation has been on the rise, hitting about 3.5% annually in 2005, as the chart above shows. To get the real return on an investment in 2005, we must subtract that 3.5% from the “nominal” return that is reported. For example, the reported total return on the S&P 500 stock index was 4.9%, but once inflation is subtracted, the real return was about 1.5%. That means an investment in the S&P 500 in 2005 increased an investor’s purchasing power by about 1.5% over the course of the year, even though the S&P 500 returned nearly 5%. An investment in a money market, savings account or any other investment earning less than the 3.5% rate of inflation effectively lost purchasing power in 2005, defeating even the most conservative goal of capital preservation.

TIPS Offer a Hedge Against the Effects of Inflation

The explicit inflation hedge offered by TIPS is important because inflation can rise suddenly and unexpectedly, as it has on many occasions in the past, as illustrated in the first chart. An unexpected surge in inflation poses a significant threat to portfolio returns. Unexpected inflation causes economic uncertainty that may lower nominal returns from traditional asset classes such as stocks and bonds, which tend to dominate most investors’ portfolios. Lower nominal returns and rising inflation can potentially result in significantly lower real returns. TIPS, with their explicit link to changes in inflation, should continue to provide predictable real returns even when inflation rises abruptly.

In the unusual event of deflation, which is a sustained fall in prices, the U.S. government guarantees repayment of principal; at maturity, investors receive the greater of the inflation-adjusted principal or the initial par amount. Interest payments on TIPS would decrease in a deflationary environment because interest payments are always based on the inflation-adjusted principal amount, which could potentially be lower than the face value of the bond in a deflationary environment.

Other Potential Benefits of TIPS in a Portfolio

Including TIPS in a portfolio of stocks and traditional bonds may provide investors with benefits in addition to inflation protection, including enhanced diversification and capital preservation.

Inflation adjustments on TIPS remove the uncertainty associated with inflation risk, so TIPS tend to be less volatile than nominal bonds, as shown in the chart below, and significantly less volatile than equities. Because of their lower volatility, TIPS can serve as a lower-risk alternative to nominal bonds, providing the potential for enhanced capital preservation in a portfolio containing riskier asset classes.

Source: Barclays Capital

¹Barclay’s US Government Inflation Linked Bond All Maturities Index

² The Barclay's US Government Break-Even Inflation Linked Bond Index

Portfolio Diversification

TIPS, because of their low volatility and link to inflation, can also enhance the diversification of an overall portfolio. In a diversified portfolio, the investment returns of the assets in the portfolio are non-correlated, meaning that a change in economic conditions may affect one investment in the portfolio but not another. Diversification does not ensure against loss, but can smooth a portfolio’s performance and is perhaps the most effective strategy for shifting the tradeoff between risk and return in an investor’s favor. TIPS have had a negative correlation with equities, and relatively low correlations with several other asset classes, notably high-yield bonds. TIPS may therefore enhance the diversification of a broader portfolio, reducing the portfolio’s volatility and potentially improving overall returns.

The Breakeven Inflation Rate

When comparing a TIPS and an ordinary Treasury bond (T-bond) of the same maturity, it's possible to assess which one is the more attractive investment by comparing the difference in their yields and deriving the "breakeven inflation rate" -- the rate for which the total return on the TIPS will be equal to that of the T-bond. If the breakeven inflation rate is lower than the actual inflation rate during the period to the bond's maturity, the TIPS will provide a higher overall return than the ordinary T-Bond.

Example

10 year Treasury note yields 4.4%

10 year TIPS note has annual fixed interest rate of 2.4%

Breakeven inflation rate = 4.4% - 2.4% = 2%.

 If the breakeven inflation rate (2%) is less than the actual inflation rate during the 10 years the TIPS is held, the TIPS provides a better return than the T-note.

Individual TIPS vs. TIPS Mutual Fund

If you buy and hold a TIPS to maturity, you will get all the CPI increases plus all the semiannual fixed rate interest payments.

If you buy a mutual fund focused on TIPS, you will get the CPI increases but if inflation occurs the principal (i.e. NAV) of the fund will go down because when inflation goes up, so do interest rates. TIPS are bonds and bond prices decrease as interest rates increase.

Purchase Example

Initial purchase

Suppose you bought $1,000 worth of 1 5/8% TIPS on Jan 15, 2008 which matures Jan 15, 2018, a 10 year TIPS (Called Series A-2018 by the Treasury Dept). The interest payment dates are July 15 and Jan 15. The index ratio can be found on the Treasury web site (see TIPS/CPI Data under Resources).

Due Diligence

• Amount purchased = $1,000
• Fixed annual interest rate = 1 5/8%
• Date purchased = Jan 15, 2008
• Maturity date = Jan 15, 2018
• Interest payment dates (twice a year) = July 15, Jan 15
• Index ratio on interest payment dates
• Principal adjustment and interest paid per year (for tax purposes)

Calculations

Adjusted principal amount = previous principal amount * index ratio

Interest payment = adjusted principal amount * fixed annual interest rate * 1/2

First interest payment calculation

The first interest payment is on July 15, 2008.

Previous principal amount = $1,000.

Index ratio: 1.02933 (on July 15, 2008)

Adjusted principal amount = 1,000 * 1.02933 = $1,029.33.

Interest payment on July 15 = 1,029.33 * 1.625% * 1/2 = 1029.33 * .01625 * 0.5 = $8.36

principal gain = adj principal - principal = $1029.33 - $1000 = $29.33

gain/loss = $8.36 + $29.33 = $37.69

Second interest payment calculation

Previous principal amount: $1,029.33

Index ratio: 102484 (on Jan 15, 2009)

Adjusted principal amount = 1,029.33 * 1.02484 = $1,054.90

Interest payment on Jan 15 = 1,054.90 * 1.625% * 1/2 = 1054.90 * 0.1625 * 0.5 = $8.57

principal gain = $1,054.90 - $1029.33 = $25.57

gain/loss = $8.57 + $25.57 = $34.14

principal	index ratio	adj principal	interest paid	gain/loss	date
1,000		1,000.00			Jan 15, 2008
1,000	1.02933	1,029.33	8.36	37.69	July 15, 2008
1,029.33	1.02484	1,054.90	8.57	34.14	Jan 15, 2009

Total gain for 2008 was $71.83 which is $54.90 + $16.93.

Federal taxes are owed on $54.90 (principal adjustment for year) and $16.93 (interest paid for year).

Note the one half interest rate is always the same.

Highlights

• Can be bought directly from the government, brokers, or banks.
• Can be bought or sold in the secondary market.
• Minimum purchase: $100 in increments of $100.
• 5, 10, or 20 year terms.
• Exempt from state and local taxes.
• Interest paid semiannually.
• Held in an online account.
• Principal is adjusted based on consumer price index (CPI).
• Fixed annual interest rate is determined when the TIP is purchased and
  remains the same throughout the life of the security.
• If deflation occurs the principal is decreased.
• If purchased in the secondary market, they can be held in a tax-deferred account.

When to Buy

If the real return (i.e. fixed annual rate) of TIPS is more than 4% that is a good time to buy.

Advantages

• Exempt from state and local taxes.
• TIPS are not callable, unlike many corporate and municipal bonds.
• Can be sold any time, though a penalty may be incurred.
• Offers a real return above inflation.
• Small minimum purchase ($100).
• Can be purchased without commissions through TreasuryDirect.
• TIPS bought in the secondary market (through a broker) can be held in an
  IRA.
• Your original principal is paid back (if held to maturity).
  even if deflation causes the adjusted principal to go below what you paid.

Disadvantages

• Taxed on the principal adjustment each year even though you do not
  receive the adjusted principal until maturity.
• If deflation occurs, interest payments may go down in value.

Taxes

• Federal tax only. Exempt from state and local taxes.
• Tax owed on interest paid and adjusted principal amount.

Due Diligence

• Amount purchased.
• Fixed annual interest rate.
• Date purchased.
• Maturity date.
• Interest payment dates (twice a year).
• Index ratio on payment dates.
• Principal adjustment and interest paid per year (for tax purposes).

Where to Purchase

• TreasuryDirect - Buy TIPS directly from the U.S. government. No expense ratio.
• Brokers.
• Banks.

Monitoring

TIPS can be monitored at TreasuryDirect.

Downloads

None

Resources

TIPS/CPI Data - current and historical CPI data for TIPS. This is where you find the index ratio for a particular TIPS.

TreasuryDirect - U.S. Treasury site for buying TIPS.

Breakeven Chart - See up-to-date breakeven inflation rate between TIPS and 10 year Treasury bond.