Inflation can be the “enemy” of bondholders.
Consider a traditional bond that pays 3 percent while inflation is only 1 percent. Your purchasing power grows since your return is greater than inflation. However, if inflation is 4 percent during the life of the bond, despite having a positive return, your bond has not kept up with inflation and your purchasing power falls.
That’s where Treasury Inflation-Protected Securities, or TIPS, come in. TIPS are issued by the U.S. government and, like other Treasury securities you may add to a portfolio, are backed by the full faith and credit of the federal government.
However, there’s a major difference: Unlike regular Treasuries, TIPS provide a potential for a total rate of return that adjusts with inflation.
How TIPS work
The principal amount of TIPS adjusts for inflation based on the Consumer Price Index (CPI), published by the Bureau of Labor Statistics. The inflation-adjusted principal value will not be realized until the issue matures or is sold.
As an example, say you own TIPS valued at $10,000 with a coupon of 5 percent. Normally, that would result in income of $500 for the year (TIPS pay interest twice a year).
- If the CPI increases by 3 percent, the principal would be adjusted by the same percentage, resulting in you receiving 5 percent of $10,300 for the year, or $515.
- If the CPI declines 4 percent, the $10,000 principal on your TIPS is readjusted to $9,600, and the 5 percent coupon gives a return of $480.
The pros and cons of TIPS
TIPS may seem like an obvious choice to help protect against inflation, but they do have pros and cons.
- TIPS allow investor purchasing power to keep pace with inflation.
- TIPS are backed by the full faith and credit of the U.S. government, and thus have low credit risk.
- Like traditional bonds, rising interest rates generally reduce the price of TIPS, just as lower interest rates drive prices higher.
- As rising prices result in a rising principal amount for TIPS, declining prices mean a declining principal value for TIPS, which can lower the return.
Generally, TIPS outperform traditional U.S. government bonds when inflation is higher than the market expects. And they underperform traditional government bonds when inflation is lower than market expectations.
TIPS and taxes
Interest payments from TIPS are subject to federal tax but exempt from state and local taxes. In addition, the amount of increase in principal value is considered taxable income at the federal level, though exempt from state and local taxes. That can create the “phantom income” effect: Increases in principal are taxed when they occur, not when they’re realized.
Work with your financial professional to determine if TIPS bonds are a good fit for your investment portfolio.
Want more details on how to defend your portfolio against inflation?
Read more about the effect of inflation on investments.