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What Are Treasury Inflation-Protected Securities (TIPS?)?
In the bond world, some of the safest investments are Treasury securities. They are issued by the United States government and carry an AAA rating, the highest level of creditworthiness. Since they reflect the “full faith and credit” of the federal government, they are virtually guaranteed never to default.
One category of Treasuries strives to protect investments from rising inflation, known as Treasury Inflation-Protected Securities, or TIPS. Their principal increases when inflation rises; conversely, when there’s deflation, they lose value.
How Do TIPS Work?
TIPS have a maturity period of 5 years, 10 years, or 30 years. They are tied to the Consumer Price Index (CPI), which means that their principal is adjusted to changes in the CPI, which is the primary gauge of inflation. TIPS are different from I bonds, another Treasury security, in that their principal is inflation-adjusted; with I bonds, the composite yield, or rate of interest, varies according to changes in the CPI.
This means that an investor might not receive the par value, or full value, of their TIPS if they decide to sell it prior to maturity. However, if an investor holds their TIPS until maturity, they receive either the adjusted principal or the original principal—whichever is greater. This is one way the government strives to entice investors into making long-term commitments through owning bonds.
Do TIPS Pay Interest?
TIPS offer interest payments on a semi-annual basis. This is known as the coupon and it is a fixed rate of return, which means it does not change through the life of the bond.
In addition, TIPS can be sold before maturity, and they are traded on secondary markets, which means there is potential for price appreciation since older bonds offer greater coupons than newer bonds.
How Are TIPS Calculated?
Every month, the Bureau of Labor Statistics publishes a report about changes in the cost of everyday life. This report is known as the Consumer Price Index. The schedule of release dates is as follows:
CPI Release Dates
TreasuryDirect, the website of the U.S. Treasury, which offers Treasury securities for purchase, also links to CPI data and publishes the most up-to-date yield rates for TIPS on this webpage.
Investors can also calculate the coupon rates themselves. They simply need to multiply the adjusted principal by one-half of the interest rate.
Are TIPS Liquid?
Interestingly, although Treasuries are prized for their liquidity, meaning they can be easily converted into cash, Treasury Inflation-Protected Securities are not considered to be as liquid as other Treasury securities, in part because their secondary market simply does not have the volume that other bond markets do.
How Are TIPS Similar to Treasury Bonds? How Are They Different?
TIPS are similar to Treasury bonds in that they are both less volatile than stocks. Owning debt securities can add ballast to a portfolio and is considered part of a balanced investment strategy since they effectively hedge against market volatility.
TIPS are different from other categories of bonds because their principal is tied to inflation, so they outperform other types of bonds when inflation is high. But, in the rare event that there’s deflation—like there was during the 2007–2008 Financial Crisis—they lose more value than other types of bonds.
How Do I Invest In TIPS? Do I Need a Broker?
You can buy TIPS through the TreasuryDirect website, or through a bank or a broker. If TIPS are held in a TreasuryDirect account, in order to sell them, you would need to transfer them to a bank, broker, or dealer who can then sell them on your behalf. This is what is known as the secondary market.
How Are TIPS Taxed?
Both the principal and the interest from TIPS are subject to federal taxes, although they are exempt from state and local taxes. You need two forms to report your tax on TIPS; Form 1099-INT, which illustrates the interest income, and Form 1099-OID, which shows the principal. These tax increases aren’t only due upon maturity; investors are liable to pay taxes on them every year.
How Can You Trade TIPS? What Are Some Examples?
In addition to investing in TIPS for the long term, which means holding them until maturity, investors can sell TIPS prior to their maturity date on the secondary market. TIPS are also available through mutual funds, bond funds, and exchange-traded funds, or ETFs.
The largest TIPS ETF is the iShares Barclays TIPS Bond Fund (TIP). Another TIPS ETF, managed by Vanguard, is the Vanguard Short-Term Inflation-Protected Securities ETF (TIPS).
However, investors who choose to own TIPS held in bond ETFs need to be careful of their holding periods. For example, an ETF has no maturity date; however, TIPS do, and often, there can be a substantial difference in profit between an investor holding TIPS to maturity or not.
Like all bonds, TIPS have an inverse relationship with interest rates, which means that when interest rates rise, bond prices fall (and vice versa). So, investors should also pay attention to interest rate risk when selecting which ETF or bond fund is right for them.
Are TIPS a Good Investment?
Since inflation is not expected to disappear anytime soon, TheStreet’s Dan Weil highlights one TIPS ETF as one of the market’s best “inflation fighter funds.”
