Investments

What Are Inflation Protected Securities

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 6 minute read

When it comes to inflation, the Federal Reserve wants to keep things at 2% each year on average. However, they have little say on the dollar’s worth or the cost of goods and services, and inflation can spike without warning. Your retirement assets, and any other investments, will lose purchasing power due to inflation.

For this reason alone, you shouldn’t keep all of your cash in a savings account. Instead, you may safeguard your savings against inflation by investing for a return that is greater than inflation. Many people are looking for inflation-proof assets after the COVID-19 outbreak and the enormous “printing” of fresh money to spend on stimulus measures.

Treasury Inflation-Protected Securities (TIPS) are a special type of U.S. Treasury bond that may be used in some of these methods to protect against inflation.

What Are Treasury Inflation-Protected Securities (TIPS)?

The value of Treasury Inflation Protected Securities rises and falls in tandem with inflation. The value of these securities is pegged by the Treasury to the inflation rate as measured by the Consumer Price Index (CPI).

They have the same governmental guarantee as ordinary Treasury bonds and are available for purchase at a predetermined interest rate. These bonds include semiannual coupon payments (interest). You will be paid interest equal to that rate multiplied by the bond’s principal value.

This is because the principal amount, and hence the amount of the semiannual payments, fluctuate with inflation.

TIPS Function

A TIPS bond’s par value fluctuates with changes in the inflation rate. Bond prices will rise proportionally more quickly when inflation rates rise. Inflation and deflation both cause changes to your payments, although in the latter case your principle and interest will be reduced.

You will get your original investment back regardless of what happens to the CPI throughout the time of your term, but you will earn no interest.

Interest rates on TIPS are often lower than those on standard Treasury bonds due to their variable principal value.

There are five-year, ten-year, and thirty-year TIPS available from the Treasury. They’re brand new and available for purchase in $100 increments from the Treasury. You may also use a brokerage account, such as SoFi Invest, to purchase them from other investors on the secondary market.

They are also available in the form of mutual funds and exchange-traded funds (ETFs) that have been securitized. These funds facilitate the instantaneous purchase and sale of TIPS; nevertheless, market conditions might cause price fluctuations.

Example

Are you still scratching your head? As many investors have discovered, TIPS operate in a manner distinct from that of traditional bonds, but you need not worry. Giving an illustration of their operation is helpful.

To illustrate, let’s pretend you invest $1,000 in TIPS bearing a 1% yield. You will earn $10 in interest (1% of $1,000) in the first year, paid out in two equal $5 installments in the spring and fall.

The rate of inflation for that first year averages 2%. At the end of the year, your $1,000 principal amount of TIPS will have increased by 2% to $1,020.

You will get 1% of the adjusted principal balance of $1,020 in the second year of ownership. That’s $10.20, payable in two $5.10 installments each half-year. This process repeats again at the conclusion of the second year of ownership, adjusting the principal amount for inflation.

In the second year, your principal will increase to $1,060.80 if inflation is 4%. Interest payments for the next year will be $10.61, or 1% on $1,060.80.

And this will continue until the bond’s maturity date has been reached. A secondary market exists wherein you may trade in your TIPS bonds if you so want. Alternately, you might hold on to them until maturity and collect the modified principal amount plus any interest accrued.

Pros & Cons of TIPS

There are some interesting pros and cons to these Treasury bonds. Before you sink your money into them, be sure you fully grasp them.

Pros

Why do individuals purchase TIPS?

  1. To avoid losing ground to inflation, one must always be ahead of the curve. Inflation can be as high as it wants, but money invested in TIPS will always rise at a greater rate. While this may not seem significant during times of low inflation (about 2%), it becomes a major issue when inflation soars (like it did in 2022) and many other higher-risk investments can’t keep up.
  2. Interest Rate Adjusted for Inflation. The bond’s face value is adjusted for inflation when it matures, and you also get interest payments that are adjusted for inflation over the bond’s term. TIPS can provide some peace of mind to retirees who are concerned about inflation eroding their savings and investment income.
  3. There is no loss of principal. You may expect to receive at least your initial investment back when the bond matures, even in the (very) rare scenario of protracted deflation.
  4. Almost no chance of defaulting. Sure, the United States government may be destroyed in a zombie apocalypse, rendering your TIPS useless. But short of it, there is essentially no credit risk for the U.S. government. And if the United States government were to fail, you’d have more pressing issues than your debt securities anyhow.
  5. Income Tax Free in All States. Interest and principal gains from TIPS are subject to federal income taxation but are exempt from taxation in most states.

Cons

Is avoiding the effects of inflation the only reason to invest?

  1. Feeble Interest Rates. Short-term Interest Payment Securities (TIPS) are a type of Treasury bond that normally provide a lower interest rate than its longer-term equivalents. To be frank, the interest rate on Treasury bonds is already rather low.
  2. Having little value while inflation is low. Inflation often does not dramatically increase. As long as it stays within the usual range of 2% to 3%, TIPS don’t offer very attractive returns.
  3. Interest savings due to deflation. If deflation causes prices to fall, your TIPS investment will likely start to look bad. Interest payments will be reduced, but you’ll still get your original investment back when the bond matures from Uncle Sam.
  4. Interest Income is subject to normal income taxation. Since you get the interest twice a year, the Internal Revenue Service treats it as dividend income rather than capital gains. Income earned from a TIPS will be subject to the top marginal tax rate.
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Should You Put Your Money Into TIPS?

When building a personal investment portfolio, inflation-protected securities issued by the Treasury can be a useful hedge. They offer inflation protection without the added volatility of precious metals or commodities.

As a result, they are low-return investments with little risk, making them a defensive safe haven if you are concerned about inflation. Due to their minimal risk, they are great for making a quick investment to hedge against inflation.

There are times when I store my funds in a TIPS ETF to protect them against inflation. Even though I routinely put money away as a real estate investor for future property acquisitions, I can never be sure of exactly when I’ll need that money. It’s possible that a good opportunity may present itself next month, but it’s also possible that I’ll have to wait a year.

However, despite the security of TIPS, you should put the bulk of your investment capital to better use in other asset classes that produce a greater rate of return. Discuss your age and long-term goals with a financial advisor to determine the appropriate asset allocation for you.

When interest rates rise, what happens to TIPS?

When interest rates rise, the value of existing TIPS, like other bonds, falls on the secondary market. When the Treasury issues new bonds that pay better interest rates, the value of the older bonds that yield a lower rate of return decreases.

However, when inflation is particularly severe, the Federal Reserve may decide to increase interest rates. A higher inflation adjustment to the face value of a bond is a net gain for TIPS holders in this scenario.

Bottom Line

TIPS are a wonderful investment option if you believe that inflation will rise in the near future. They are a simple way to protect against inflation because they carry almost little risk of loss and can be quickly converted into cash. The safety of your investment is ensured by a federal government guarantee.

However, this in no way indicates high wages. It’s very possible that you’ll earn no more than 10% annually, which is less than the long-term average return on equities. TIPS should be part of a more conservative portfolio allocation for inflation protection rather than the primary vehicle for growing your money.

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