Key takeaways

  • At a time when inflation has taken on greater significance, it’s important to make sure your investments keep pace with living costs.

  • Treasury Inflation-Protected Securities, or TIPS, are unique fixed income securities that provide inflation protection.

  • TIPS may be appropriate to consider for a portion of your portfolio, depending on your investment goals.

Fixed income investments play a role in most portfolios. A challenge is positioning those assets in a way that inflation—the rising cost-of-living—won’t significantly damage your investment returns.

Inflation surged at the beginning of 2021 for the first time in years. By mid-2022, inflation far outpaced typical bond yields. Over most of this period, those who owned 10-year U.S. Treasury bonds (a benchmark for bond investors) found that income failed to keep pace with inflation. For traditional bond holders, that portion of the portfolio lost ground to the higher cost of living.

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

This is 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.

“TIPS tend to perform best in periods when the interest rate environment is relatively stable but inflation is suddenly moving higher.”

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

Unlike regular Treasuries, however, TIPS provide the potential to earn a total return that reflects the impact of 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 for U.S. Bank Wealth Management.

 

How TIPS work

TIPS bonds account for inflation by adjusting the principal value of the securities in line with the inflation rate as reflected in the Consumer Price Index (CPI), which is published by the U.S. Bureau of Labor Statistics. When the cost-of-living as measured by CPI increases, the principal value of a TIPS security rises to reflect that change. If deflation occurs and CPI declines in value, the principal value of TIPS declines as well.

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

As an example, say you own TIPS valued at $10,000 with a coupon of 5%. Based on the initial principal value, that would result in income of $500 for the year (TIPS pay interest twice a year).

  • If the CPI increases by 3%, the principal would adjust by the same percentage, resulting in you receiving 5% of $10,300 for the year, or $515.
  • If the CPI declines 4%, the $10,000 principal on your TIPS is readjusted to $9,600, and the 5% coupon gives a return of $480.

Notably the interest rate remains constant, but as the principal value fluctuates, the actual interest paid by TIPS will adjust in a corresponding manner.

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 amount. TIPS Inflation Index Ratios1 are provided by the U.S. Treasury department to help calculate the impact on bonds.

Since TIPS typically pay an interest rate that is lower than that offered by a comparable Treasury security, investors may not benefit from inflation protection if cost-of-living changes are minimal over the holding period.

 

How do TIPS protect against inflation?

While the principal value of TIPS adjusts in line with the inflation rate, they typically pay a lower interest rate than comparable Treasury securities. In essence, investors trade off current yield for inflation protection. Compare these recent yields on U.S. Treasury securities and TIPS.

Charts compares recent initial offering yields for 30-year, 10-year and 5-year TIPS versus Treasury bonds.
Source: U.S. Department of the Treasury. 30-year Treasuries issued on Feb.1, 2023, 30-year TIPS issued on Feb. 16, 2023; 10-year Treasuries issued on Feb. 15, 2024, 10-year TIPS issued Jan. 18, 2024; 5-year Treasuries and 5-Year TIPS issued Oct. 19, 2023.

What is the difference between TIPS and traditional bonds?

Like traditional Treasury bonds, TIPS are issued by the U.S. government and backed by the full faith and credit of the federal government. However, TIPS principal can fluctuate over the security’s term, based on the inflation rate. This is different from a traditional bond, where the dollar value of the payout is determined based on the applicable interest rate when the bond is initially purchased.

Yet TIPS are still subject to price changes created by the underlying interest rate environment. “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,” says Haworth. “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.”

 

How often do TIPS bonds pay interest?

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 can change as well.

 

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.

The increase in principal value generated in a given year results in a “phantom income” effect, because the increases in principal are taxed in the year they occur, even if the gains are not realized.

 

Opportunities and risks with TIPS

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

Opportunities:

  • TIPS offer a unique opportunity for 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, and thus have low credit risk.
  • Both underlying principal and the income generated 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:

  • As is the case 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.
  • Appreciation in principal value is taxable even before those gains are realized.

“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.” Yet Haworth notes that even in times when inflation is higher, TIPS may not perform as well as an investor might expect if interest rates are also on the rise.

 

What is the outlook for TIPS in 2024?

While inflation is still considered elevated (consistently in the 3.0% to 3.5% range since mid-2023), there are no immediate reasons to anticipate inflation reversing course and moving significantly higher in the near term. “We would need to see something change, or an event such as a crisis that would result in supply constraints,” says Haworth. “The tight labor market remains an inflation risk as well, should wage gains accelerate from current levels.”

Investors should assess inflation expectations or consider the degree of inflation protection they need in their fixed income portfolios before making TIPS investment decisions.

 

How to invest in TIPS

TIPS are issued at various times throughout the year and are sold in $100 increments. TIPS can be purchased 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.

Work with your financial professional to 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. 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.

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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.