What is Treasury inflation-protected security? What you need to know

treasury inflation protected securities

Inflation can deplete your purchasing power unless there’s an inflation-adjusted rise in income. It also chips away at the value of long-term investments when the interest rates are lower than the rate of inflation.

Since both of these scenarios are concerning, investors often go for instruments that help offset inflation. Treasury Inflation-Protected Securities (TIPS) can be one such inflationary hedge, besides possibly gold and other commodities.

Table of Contents

  1. What are Treasury Inflation-Protected Securities?
  2. What is the significance of TIPS?
  3. How do TIPS work?
  4. TIPS vs. I-Bonds
  5. TIPS and Taxes
  6. What are the benefits of TIPS?
  7. The risks and disadvantages of TIPS
  8. How to get started with TIPS?

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What are Treasury Inflation-Protected Securities?

Treasury Inflation-Protected Securities, or TIPS, are government bonds issued by the U.S. Treasury, whose value is indexed to inflation based on the Consumer Price Index for All Urban Consumers (CPI-U). TIPS are thus fixed-rate treasury securities that can help protect your purchasing power.

TIPS are a relatively new form of treasury bond. The U.S. Treasury auctioned TIPS for the first time in January 1997, catering to strong market demand. But over the years, this inflation-indexed asset class has emerged as a significant alternative to other bond funds, such as I-Bonds.

This in-depth blog will thus provide a guide to help you make informed investment decisions regarding TIPS. We’ll discuss everything you need to know about TIPS, including what they are, why they matter, and how they work.

We’ll also highlight the crucial factors to remember while exploring and starting with TIPS. So let’s begin.

Key Takeaway

  1. TIPS are inflation-linked bond instruments issued by the U.S. Treasury, helping investors hedge against inflation.

  2. TIPS work with inflation-adjusted principal value while offering fixed interest rates.

  3. The inflation data for TIPS is derived from the Consumer Price Index for all Urban Consumers (CPI-U), provided by the U.S. Bureau of Labor Statistics.

  4. TIPS can be seen as an alternative to I-Bonds, though each has its pros and cons.

  5. TIPS are marketable treasury securities that can help diversify your portfolio and can also be traded in the secondary market.

What is the significance of TIPS?

Inflation is commonly understood as the general increase in the price of goods and services in an economy. Caused by various factors like increasing currency supply or decreasing production, inflation has been a serious concern in the US since 2020-2021, following COVID-19.

12 Month Consumer Price Index

Source: BLS.gov

The problem with inflation is that it decreases the consumer’s purchasing power over time. Suppose the inflation rate is 5% from Year A to Year B. This means you can purchase 5% less in Year B than in Year A if your income stays flat. Thus, inflation effectively makes you poorer unless your income rises by the same amount as inflation.

Besides retail affordability, inflation also corrodes your savings and investments when the interest rates are lower than inflation rates. This particularly applies to instruments like bonds and deposits that pay a fixed interest throughout their tenure.

TIPS, however, are designed to combat inflation risk since their value is adjusted according to current inflation rates. This may help you offset the volatility in retail prices, especially significant during periods of high or rising inflation.

Nevertheless, although TIPS can be a relatively low-risk instrument, they too have certain risks and disadvantages, as we shall discuss later.

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An overview of TIPS

Mode of IssuanceDigital
Maturity PeriodsTIPS have three maturity options: Short-term: Five (5) years Medium-term: Ten (10) years Long-term: Thirty (30) years
Interest Rate(s)TIPS have a fixed interest rate, equal to or more than 0.125%, decided at the time of auction. TIPS also have provisions for allowing negative real yield bids.
Interest Payment CycleTIPS’ interest payments are made bi-yearly, once every six months till maturity.
Minimum Purchase$100
Maximum PurchaseThe maximum purchase value for TIPS depends on the type of bid: $10 million for non-competitive bids 35% of the offering amount for competitive bids
Increments Amount$100
Auction CycleTIPS bonds have different auction cycles based on their maturity period: 5-year TIPS: Originally issued in April and October. Reopened for increments in June and December. 10-year TIPS: Originally issued in January and July. Reopened for increments in March, May, September, and November. 30-year TIPS: Originally issued in February. Reopened for increments in August.
STRIPS EligibilityYes

How do TIPS work?

As an inflation-protected bond instrument, TIPS function by adjusting the original principal according to current inflation based on the CPI-U. Thus, despite having a static rate of return like ordinary fixed-income securities, TIPS provide dynamic, inflation-adjusted returns every six months.

Let’s consider a hypothetical example to understand how TIPS work. Suppose you have a five-year TIPS worth $100 in face value, purchased with a coupon rate of 3%. This coupon rate remains constant till the maturity date. However, the bond’s par value or principal amount is inflation-adjusted at the time of interest payments.

Thus, when there’s no inflation, the said TIPS gives you a $3 return, i.e. 3% of $100. But if the current inflation rate is, say, 5%, the original principal is adjusted to $105 so that you receive a return of ~$3.15 (3.5% x $105).

Having said that, it’s noteworthy that TIPS are correlated not only with inflation but also deflation. This means the par value of TIPS bonds is adjusted negatively when there’s deflation. However, investors don’t usually face losses due to such adjustments since they receive the original (purchase) principal if it’s greater than the current principal value at maturity.

For example, if your TIPS bond, whose original principal was $100 at purchase, is adjusted for deflation to $95 at the end of five years, you’ll still receive $100 while closing the bond.

Note: You can read our blog on how to cash a treasury bond to know more about cashing out of TIPS.

TIPS vs. I-Bonds

Having discussed how TIPS work vis-à-vis inflation and deflation, comparing them with other inflation-linked bonds might provide further clarity on this subject. The comparison may be particularly useful for those confused between similar bond instruments like TIPS and Series I Savings Bonds.

MarketabilityYes. You can buy and sell TIPS in the secondary market for securities.No. You can’t buy or sell I-Bonds in secondary markets since they are registered to a particular entity’s name and are non-transferrable.
AvailabilityTIPS are available in digital formats only, purchasable online at TreasuryDirect or through brokers, banks, etc.You can purchase I-Bonds online from the TreasuryDirect website. Paper versions are also available using tax refunds.
Purchase Capping$10 million for non-competitive bids and up to 35% of offering amount for competitive bids.$10,000 per annum per Social Security number for electronic purchases and $5,000 per annum per Social Security number for paper bonds.
Minimum Purchase & Increment Amounts$100 minimum purchase, and $100 increments.$25 minimum purchase value, and increments in five denominations: $50, $100, $200, $500, and $1000.
Inflation AdjustmentBased on monthly CPI-U.Based on semi-annual CPI-U, published by the U.S. BLS in May and November.
Maturity Periods5, 10, and 30 years.30 years
Rate of ReturnThe coupon rate is fixed at purchase, while the par value is adjusted to inflation.The rate of return is calculated by combining the I-Bonds interest rate and the current inflation rate.
Interest PaymentsSemi-annually, once every six months.One-time cumulative interest paid upon redemption.
Tax CycleTIPS are subject to annual federal taxes.Taxes for I-Bonds can be reported and paid at the time of redemption or maturity, whichever is earlier.
Premature Closure or DisposalTIPS are sellable in secondary markets prior to maturity.I-Bonds can be redeemed after twelve months from issue by paying a penalty worth three-month’s interest. No penalty is charged if the bond is redeemed after five years from issuance.

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TIPS and Taxes

The U.S. government subjects TIPS to Federal-level taxation while exempting them from state and local taxes. So you are obligated to pay annual taxes on the earnings from TIPS held in your investment account.

However, calculating income taxes for TIPS can be a bit tricky if you are unaware of the nuances. That’s because earnings from TIPS include both the interests received and the face value appreciation. Thus, if the principal amount is adjusted from $100 to $110 in a given year, you’re expected to report this gain in that year’s tax filing.

Therefore, a component of the taxes on TIPS is payable prior to actually receiving the gains. This is because the appreciated principal amount is redeemable only at maturity. So it’s advisable to consider this discrepancy to avoid unforeseen tax burdens while investing in TIPS.

The silver lining here is that you can similarly offset gains by reporting losses on the principal amount if there’s deflation.

What are the benefits of TIPS?

The foremost advantage of TIPS for inflation-conscious investors is that it’s a relatively low-risk instrument. For instance, since TIPS are backed by the full faith and credit of the U.S. government, they have minimal credit risk. Moreover, TIPS usually have deep liquidity which makes entering and exiting the bond market easier for investors.

Besides the general benefits of bonds, TIPS additionally provide an easy to use and accessible inflation hedge. For one, the interest calculation for TIPS is pretty straightforward, which may prove useful for amateur investors. And since TIPS are also accessible via mutual funds and ETFs, they can cater to diverse investment strategies.

The risks and disadvantages of TIPS

TIPS aren’t 100% risk-free, just like any other investment instrument. Listed below are some of the key disadvantages of TIPS.

  • TIPS usually provide lower yields compared to other treasury securities or corporate bond funds. This especially applies to periods of low inflation or, more rarely, deflation. Moreover, fixed-rate bonds often implement certain market-driven mechanisms to factor inflation.
  • Although TIPS tend to provide steady income, the amount fluctuates due to the instability of inflation rates. This may make investment management difficult for some investors, particularly if there’s high uncertainty.
  • CPI provides a generalized view of inflation which may not necessarily ensure adequate inflation-adjustment according to your financial needs and spending patterns.
  • TIPS usually trade in liquid bond markets but it may be challenging to sell them off when inflation is fluctuating. Moreover, selling TIPS prematurely may entail capital losses if the current principle is lower than the original bond price.
  • Paying anticipatory taxes for TIPS can be a trouble for certain investors, especially when their income-spending margin is low.

Quick Tip

  1. You can partially avoid the burden of anticipatory taxes by holding TIPS in tax-advantaged accounts and using them as savings for retirement.

How to get started with TIPS?

You can purchase TIPS directly from the Treasury Direct website or you can avail of brokerage services to invest in TIPS through mutual funds or exchange-traded funds.

The first method is usually more cost-effective since you needn’t bear additional costs like brokerage fees. However, purchasing TIPS directly from the Treasury can be a hassle for some investors, especially if they aren’t familiar with auctions and bidding.

You can get more details about purchasing TIPS by reading our in-depth blog on how to buy a treasury bond. Suffice to say for now that no matter how you acquire TIPS, they can help with the diversification of your investment portfolio.

So, if that fits your investment strategies and needs, you may consider exploring ETFs that include TIPS on Public. Our ‘Long-Term Portfolio’ feature allows you to easily earmark your TIPS ETF holdings and cautions you of unintended or accidental sale.

We also offer instant transfers so that you can quickly deposit or withdraw funds while cashing in and out of TIPS ETFs. This can lower your opportunity costs, besides increasing your chances of grabbing available premiums.

Public also opens the door for you to interact with an active community of experts and amateurs. You can discuss macroeconomic trends, market dynamics, and investment decisions with peers, thus making more informed choices about TIPS.

Coupled with intuitive platform-level features, our social investing aspect can significantly boost your experience of investing in TIPS. So if you’ve done your due diligence and decided to invest in TIPS, you might want to get started with us. We have a lot to offer.

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Frequently Asked Questions (FAQs)

Can TIPS lose money?

Since TIPS provide you with the inflation-adjusted principal or the original principal amount, whichever is higher, at maturity, you are unlikely to lose money on TIPS if you hold them until maturity. However, if you prematurely cash out of your TIPS holdings during a deflationary period when the inflation-adjusted principal is lower than the original principal, you may lose money on the said TIPS holding.

Can I buy TIPS for my IRA?

Yes, you can purchase TIPS for your Individual Retirement Account or IRA in any form, i.e. TIPS bonds or TIPS-based mutual funds. However, you cannot buy such TIPS directly from the TreasuryDirect website and need to buy them through the brokerage platform where you manage your retirement accounts, such as Public.

What yields do TIPS have?

TIPS can have varied coupon rates and overall yield depending on several factors, including current and projected inflation, as well as the subsequent demand for TIPS in the bond market. The fixed interest rate, decided at auction, is never lower than 0.125%. However, certain short-term TIPS have also offered 1.625% with an yield of around 1.732%, according to data from the U.S. Treasury.

What does “inflation-protected” mean?

The term “inflation-protected” is used to denote the feature that allows TIPS to serve as a possible hedge against inflation. To achieve this purpose, the principal value of your TIPS holdings is automatically adjusted according to the current Consumer Price Index (CPI-U), as published by the U.S. Department of Labor, Bureau of Labor Statistics. This index is the benchmark for calculating inflation in the U.S. economy.

What is the difference between a Treasury Bond and a Treasury Inflation-Protected Security (TIPS)?

TIPS are in fact a subset or special category of Treasury Bonds, partly similar to other government-issued bonds like I-Bonds. However, TIPS are designed to adjust the principal value based on the current inflation rate, unlike ordinary fixed-income Treasury bonds. TIPS are also different from peers like I-Bonds, since they work with a dynamic principal rather than a dynamic interest rate.