A fixed-income investment designed to outpace inflation sounds appealing.
That’s the idea behind Treasury inflation-protected securities (TIPS), which are Treasury securities with principal and interest payments that are adjusted for inflation.
[Sign up for stock news with our Invested newsletter.]
Many investors are drawn to these bonds in an era of rising inflation. Here’s a look at what TIPS are, and whether they’re a sound investment as inflation remains stubbornly sticky:
— What are TIPS?
— How are TIPS different from other Treasury investments?
— Pros and cons of investing in TIPS.
— TIPS in today’s market climate.
— Ways to further lower risk with TIPS.
What Are TIPS?
Here’s a short rundown of TIPS’ key characteristics.
— Principal protection. When you buy a TIPS bond, you are guaranteed to receive its full face value at maturity. This means that even if there is deflation, and the consumer price index (CPI) decreases, the principal value of your TIPS bond won’t be reduced.
— Interest payments. The interest payments on TIPS bonds are adjusted for inflation. The interest rate, also known as the coupon rate, is fixed at issuance, but the interest payments adjust with changes in inflation. As the CPI rises, interest payments increase, giving investors a hedge against inflation.
— Taxation. Although TIPS bonds protect against inflation, they’re still subject to federal income tax on interest payments and any capital gains. However, investors don’t incur state or local income taxes on interest earned from TIPS.
How Are TIPS Different From Other Treasury Investments?
Unlike traditional bonds, TIPS adjust both principal and interest payments based on changes in the CPI. The idea is that TIPS can help investors maintain purchasing power when prices are rising.
That’s not an aim of other Treasury investments.
“Think of regular Treasuries as reliable but a bit predictable,” said Sean Lovison, founder and lead planner at Purpose Built Financial Services in Moorestown, New Jersey.
“They pay a set rate; inflation be damned,” Lovison said in an email. “Conversely, TIPS offer a twist: Their principal moves with inflation, ensuring your money doesn’t lose value when prices rise.”
TIPS vs. Series I Bonds
TIPS are often compared with Series I bonds
because they both offer inflation protection. Series I bonds are U.S. government savings bonds that offer a fixed rate, combined with a rate adjustment for inflation.
“But there are several differences between the two,” said Dennis De Kok, founder and senior wealth advisor at FCM Financial Planning in Grand Rapids, Michigan.
He noted three key differences between Series I bonds and TIPS:
— TIPS can be resold on the secondary market, while I-bonds cannot.
— TIPS can be bought in three different maturities, but I-bonds are sold in 30-year terms only.
— Investors can buy an unlimited number of TIPS on the secondary market, but I-bonds have an annual limit of $15,000 total. That breaks down to $10,000 in electronic bonds and $5,000 in paper bonds.
[How to Become a Millionaire by Investing]
Pros and Cons of Investing in TIPS
Like any other investment, TIPS have both pros and cons.
On the positive side, says Lovison, “TIPS are fantastic if you’re worried about rising costs eroding your investments. They provide peace of mind that your portfolio has a built-in shield against inflation.”
However, he says, there’s a tradeoff.
“TIPS tend to underperform traditional Treasuries when inflation is low or declining,” Lovison says. “Plus, just like all bonds, TIPS’ price reacts to interest rate changes and tends to underperform equity over more extended periods. It’s insurance, not a get-rich-quick scheme.”
TIPS in Today’s Market Climate
TIPS have advantages over other types of bonds when it comes to offering protection against inflation. However, bonds as a broad asset class underperform stocks in the long haul. Historically, stocks have been the best investment to stay ahead of inflation.
De Kok says TIPS can be a good option for investors who are concerned about inflation and want a safe place to salt away some cash.
The best time to buy TIPS, he says, is when an investor expects inflation to increase, as this would increase the principal and interest payments over that period.
“Since interest rates are high and the Fed is currently intent on lowering inflation, it’s probably not the best time to invest in TIPS,” he says.
With inflation and Federal Reserve monetary policy top of mind for investors, though, TIPS have gotten a lot of attention lately.
“While appropriate as an instrument to protect wealth, TIPS are not considered a primary vehicle to build wealth,” says Robert Johnson, chairman and CEO at Economic Index Associates in New York.
Lovison has the same caution for investors, adding that as interest rates rise, prices of bonds, including TIPS, have been under short-term pressure.
“However, the specter of inflation remains, and with a potential recession on the horizon, TIPS could prove a valuable hedge in volatile times,” Lovison said.
Ways to Further Lower Risk With TIPS
There are some steps investors can take if they want to reduce portfolio risk using TIPS.
For example, investors might consider holding bonds until maturity. That ensures that a bond investor will receive the full principal value adjusted for inflation, minimizing the loss of purchasing power.
“For maximum stability, consider building a TIPS ladder,” says Lovison. “Instead of putting everything into a single issue, stagger maturities over time. This smooths out interest rate sensitivity and ensures you always have some TIPS coming due soon.”
More from U.S. News
9 of the Best Bond ETFs to Buy Now
7 Best Vanguard Bond Funds to Buy
How to Invest in TIPS: Treasury Inflation-Protected Securities originally appeared on usnews.com
Update 03/22/24: This story was previously published at an earlier date and has been updated with new information.
