Guide to understanding Treasury Inflation-Protected Securities (TIPS)

What are Treasury Inflation-Protected Securities (TIPS)?

TIPS are a specific type of inflation-linked treasury bond designed to protect the investor from inflation, which is a common concern among other types of bonds. Almost all bonds, because they are low risk, also have a low return on investment — usually somewhere around 4%–6% annually, depending on the term length. In times of high inflation, bonds can actually lose purchase power over the course of their maturity.

TIPS are a low-risk way to diversify your portfolio and hedge against uncertainty in future inflation rates. Every six months, the principal of your investment is adjusted based on the CPI, one of the main indicators of inflation. In theory, the money you get in return upon maturity should have the same purchase power as your initial investment.

What are U.S. government bonds?

U.S. government bonds, also known as Treasuries, are debt securities issued by the U.S. to fund the government. When you buy a bond, you are essentially lending money to the government in exchange for periodic interest payments and the return of the principal amount when the bond matures. They are considered low-risk investments because they are backed by the U.S. government, but they often offer lower returns than other investments¹. There are a few different types of U.S. government bonds that differ by their maturity dates and how they pay interest. The most common are:

• Treasury Bills (T-bills)
• Treasury Notes (T-notes)
• Treasury Bonds (T-bonds)
• Treasury Inflation-Protected Securities (TIPS)
• Series I bonds
• Series EE bonds

How do TIPS work?

When you purchase TIPS, you are functionally loaning a certain amount of money to the U.S. government. Here are some terms you should understand:

• The principal is your initial investment amount and can range anywhere from a minimum of $100 to a maximum of $10 million (when purchasing directly from the government).
• The interest rate or “coupon rate” is the percentage of the principal you’ll receive as payment each six-month period.
• The length until maturity is when you receive your full principal back at the end of the bond term and can be five years, 10 years, or 30 years.

Every six months, while you own the bond, you will receive interest payments based on the principal and interest rate. For TIPS, the principal is readjusted by the inflation rate each period. Then at the end of the bond, called maturity, you receive your initial investment back (also adjusted for inflation).

Nominal vs. real returns: An example

When talking about investing money over time, you need to take into account how the purchasing power of money changes. This is called inflation, or on rare occasions, deflation. Simply put, $10 in 1990 was worth more than $10 today. You could buy more with it. When you apply this concept to investments, it is often called a nominal vs. real return. Real return is almost always a more useful metric to use when planning your investment strategy.

Nominal return is the actual stated percentage gain on an investment. It reflects what’s earned in dollar terms.

Real return adjusts that nominal return for inflation, showing how much the purchasing power of that money actually increased. Since TIPS are automatically adjusted for inflation, their listed interest rate is always real return.

Here’s an example:

Let’s say you purchase $10,000 in 10-year bonds with a 2% interest rate.

With a nominal bond, you’d get a $200 payment every six months for 10 years, then receive your original $10,000 back, for a total return of $14,000. However, if you estimate 3% annual inflation over those 10 years, $14,000 only has the actual purchase power of about $10,417.94 in today’s dollars, so it’s basically a wash. In this case, the nominal return was 2%, but the real return based on inflation was actually -1%. Not a great investment.

If you purchased TIPS instead, the principal would rise with inflation. After one year, the principal of your initial $10,000 investment would be $10,300. You’d receive 2% of that new number in interest—$206 instead of $200 in the previous example. After five years of steady 3% inflation, your principal will be approximately $11,600 and your interest payment will be $232. Then, at the full maturity of 10 years, you’ll receive back your principal adjusted for inflation—about $13,500, which should have the exact same purchase power as your initial $10,000 investment does when you purchase the bond. In this case, because TIPS are already adjusted for inflation, the real return is 2%, and the nominal rate is actually 5%.

Benefits and drawbacks of TIPS

U.S. Treasury bonds are considered one of the lowest-risk long-term investments you can make, because they are backed by the U.S. government, which is historically considered unlikely to default. Because of that low risk, however, they also offer limited returns. Here’s a breakdown of the benefits and drawbacks of TIPS:

One additional important consideration with TIPS is that the interest earned counts as taxable income in the year it was received, even if the bond has not reached maturity.

How to buy and invest in TIPS

There are two primary ways to purchase TIPS. The first is directly through the U.S. Treasury at TreasuryDirect.gov. The Treasury holds scheduled auctions throughout the year, which allows you to purchase TIPS of different maturity lengths in increments of $100.

The second way to purchase TIPS is indirectly through financial institutions, such as banks, brokers, or on the secondary market. TIPS might also be included in some mutual funds and exchange-traded funds (ETFs). If you are purchasing bonds second-hand, be aware of any fees you may pay that are on top of the initial investment principal.

Who should invest in TIPS?

TIPS are generally considered more suitable for conservative investors, often those already at retirement age that are looking to preserve wealth already accumulated rather than grow more wealth. That is true of most bonds, however. The decision to choose a traditional U.S. Treasury bond vs. TIPS is a little more nuanced. You must compare the potential real returns of nominal-rate bonds vs. the real rate of TIPS. It comes down to this: If you think inflation is going to be high over the life of your bond (five, 10, or 30 years), TIPS might be more beneficial. If you think inflation is going to be relatively low and steady, a traditional bond may perform better. Either way, you shouldn’t make such an important investing decision without first consulting a qualified financial professional.

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¹US government bonds are subject to interest rate risk; when the rates rise the value of existing government bonds declines.