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Key takeaways

  • Earnings on bonds can often fail to keep pace with inflation.

  • Treasury Inflation-Protected Securities, or TIPS, are fixed-income securities that provide inflation protection. TIPS premiums increase when the Consumer Price Index rises and decrease when the CPI falls.

  • It’s important to understand the risks and consult with a financial professional before investing in TIPS bonds.

Inflation is a significant factor for investors who rely on a steady stream of income from bonds and other fixed-income instruments. Rising living costs can eat away at a bondholder’s purchasing power if income remains constant.

Treasury Inflation Protected Securities (TIPS) were created to help at least partially address fixed income portfolios’ inflation risk.

 

Inflation’s effect on investment portfolios

Let’s take a minute to look at inflation in recent years. The cost of living, as measured by the Consumer Price Index (CPI), started to rise in 2021 and peaked in mid-2022. During that period, inflation far outpaced typical 10-year U.S. Treasury bond yields.1 Bond investors found their portfolios losing ground to inflation.

“For a long-term investor, TIPS can offer an opportunity for an investment that keeps pace with living costs. If there are inflation surprises down the road, TIPS investors will have a degree of protection.”

Rob Haworth, senior investment strategy director, U.S. Bank Asset Management

However, by mid-2023, inflation tapered off, and bond yields rose, putting fixed income investors in a more favorable position.1

Chart depicts the relationship between inflation and 10-year Treasury yields for the time period 2021 - 2024.
Consumer Price Index (CPI), provided by the U.S. Bureau of Labor Statistics, for the previous 12-month period. 10-year Treasury yields provided by the U.S. Department of the Treasury. As of December 31, 2024.

Recent experience highlighted TIPS’ potential benefits. Because TIPS earnings are essentially adjusted for inflation, TIPS investors saw income streams grow more significantly during the high inflation period. When inflation is more muted, income may rise, but not as significantly.

TIPS are issued by the U.S. government and, like other Treasury securities, are backed by the full faith and credit of the federal government. Unlike regular bonds, however, TIPS provide the potential to earn a total return that reflects inflation.

“For a long-term investor, TIPS can offer an opportunity for an investment that keeps pace with living costs,” says Rob Haworth, senior investment strategy director with U.S. Bank Asset Management. “If there are inflation surprises down the road, TIPS investors will have a degree of protection.”

 

How TIPS bonds work

TIPS bonds account for inflation by adjusting the principal value of the security in line with the inflation rate. When CPI rises, the principal value of a TIPS bond also rises. If deflation occurs and CPI drops, the principal value of TIPS drops, too.

Source: U.S. Bank Asset Management Group. For illustrative purposes only and not based on specific historical outcomes.

As an example, say you own a TIPS bond valued at $10,000 with a coupon of 2%. Based on the initial principal value of $10,000, you would see income of $200 for the year.

Now let’s look at what would happen in the case of inflation or deflation:

  • Inflation: If CPI increases by 3%, the principal adjusts by the same percentage (adding $300 to your original principal). As a result, you receive 2% of $10,300 for the year, or $206.
  • Deflation: If CPI declines 4%, the $10,000 principal on your TIPS bond readjusts to $9,600, and the 2% coupon pays income of $192. Historically, prices rarely decline on a year-to-year basis.

Note that the coupon rate (2%, in this example) remains constant, and changes in CPI do not affect the coupon rate. The inflation-adjusted principal value is not realized until the issue matures or is sold. At that time, the investor receives the higher of the adjusted principal value or the original principal value. You will never receive less than the original principal value.

TIPS Inflation Index Ratios2 are provided by the U.S. Treasury department to help calculate the impact on bonds.

 

How do interest rates affect TIPS bonds?

First, you should be aware that TIPS typically pay a lower yield than comparable Treasury securities. In essence, you trade off current yield for inflation protection.

In terms of the interest rate’s impact, Haworth notes that just as with other Treasury securities, TIPS are at a disadvantage when rates rise, or during periods of modest inflation.

“When interest rates are rising, prices of TIPS are subject to a loss in value just as is the case with other types of bonds,” he says. “The impact of inflation is still reflected in the price of TIPS, but they’re also subject to changes in the broader interest rate environment.”

 

Opportunities and risks with TIPS

As you think about how TIPS might fit into your portfolio, it can be helpful to weigh the opportunities they provide along with the risks.

Opportunities with TIPS

  • TIPS allow bond investors to achieve a degree of inflation protection not available in most other fixed-income investments.
  • TIPS are backed by the full faith and credit of the U.S. government, meaning they have low credit risk.
  • Both underlying principal and the income it generates can rise in line with the rate of inflation.
  • At maturity, the principal value of TIPS will be no lower than your initial investment.

Risks with TIPS

  • As with traditional bonds, the underlying value of TIPS can decline in times when interest rates are rising.
  • In deflationary times, the value of TIPS and income generated from them will decline.
  • Any appreciation in principal value is taxable even before you realize those gains.

These are also good talking points when meeting with a financial professional.

Frequently asked questions about TIPS bonds

TIPS are issued at various times throughout the year and are sold in $100 increments. You can purchase TIPS through the U.S. Treasury website with maturities at auction of 5, 10 or 30 years. You can also purchase bonds with interim maturities through a bank or brokerage firm, or directly online. Certain mutual funds and exchange traded funds (ETFs) may also invest in TIPS, an approach that can provide tax advantages (see “Are TIPS bonds taxed?” below).

“TIPS tend to perform best in periods when the interest rate environment is relatively stable but inflation is suddenly moving higher,” says Haworth. “In periods like these, the inflation adjustments in TIPS can provide some advantages.”

After a period of elevated prices, inflation recently dropped below 3%, closer to its long-term average. “In this environment, TIPS’ potential benefits are less evident,” says Haworth. He notes that given the recent yield environment, TIPS may look competitive with traditional government bonds.

Haworth says in today’s environment, investors seeking yield advantages may also consider non- government agency issued residential mortgage-backed securities, collateralized mortgage obligations (CMOs) or, where appropriate, reinsurance pools.

TIPS pay interest every six months until the bond’s maturity. The rate of interest is fixed and based on the underlying principal value. Since the principal value can change, the interest amount can change as well. This is unlike a conventional Treasury bond, which pay a constant income stream regardless of market or inflationary conditions.

Tax treatment of TIPS is a significant consideration. Interest payments from TIPS are subject to federal tax but are exempt from state and local taxes. In addition, if the principal value increases, the amount of that increase is taxable at the federal level in the year it occurs. “It’s best to own TIPS through a mutual fund or exchange traded fund (ETF),” says Haworth. “If you purchase TIPS directly, you’ll owe taxes on the imputed interest inflation adjustment.” This is an effect referred to as “phantom income.”

The inflation-adjusted principal value isn’t realized until the bond issue matures or you sell it. At that point, you would receive the adjusted principal value or the original principal value, whichever is higher.

You will never receive less from a TIPS bond than the original amount you paid for it.

TIPS Inflation Index Ratios2 are provided by the U.S. Treasury Department to help calculate the impact on bonds.

Seek professional advice before investing in TIPS bonds

Before buying TIPS bonds, you should assess current inflation expectations or consider the degree of inflation protection you need in your fixed-income portfolio. A financial professional can help you determine if TIPS are a good fit for your investment portfolio.

Learn how we approach investment management.

Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning the construction of portfolios and how investments should be allocated to specific asset classes based on client goals, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio. Diversification and asset allocation do not guarantee returns or protect against losses.

Indexes mentioned are unmanaged and are not available for investment.

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Disclosures

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  1. Source: U.S. Bureau of Labor Statistics.

  2. TIPS/CPA Data, TreasuryDirect.

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Investment and insurance products and services including annuities are:
Not a deposit • Not FDIC insured • May lose value • Not bank guaranteed • Not insured by any federal government agency.

U.S. Wealth Management – U.S. Bank is a marketing logo for U.S. Bank.

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U.S. Bank and its representatives do not provide tax or legal advice. Your tax and financial situation is unique. You should consult your tax and/or legal advisor for advice and information concerning your particular situation.

The information provided represents the opinion of U.S. Bank and is not intended to be a forecast of future events or guarantee of future results. It is not intended to provide specific investment advice and should not be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation.

U.S. Bank does not offer insurance products but may refer you to an affiliated or third party insurance provider.

U.S. Bank is not responsible for and does not guarantee the products, services or performance of U.S. Bancorp Investments, Inc.

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Past performance is no guarantee of future results. All performance data, while obtained from sources deemed to be reliable, are not guaranteed for accuracy.

Investments in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investment in fixed income securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities.

Treasury Inflation-Protected Securities (TIPS) offer a lower return compared to other similar investments and the principal value may increase or decrease with the rate of inflation. Gains in principal are taxable in that year, even though not paid out until maturity.