Treasury Inflation-Protected Security (TIPS)

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Treasury Inflation-Protected Securities (TIPS)

Key takeaways

  • TIPS are U.S. Treasury bonds indexed to inflation (CPI) to protect purchasing power.
  • The principal adjusts with CPI; interest is paid semiannually on the inflation-adjusted principal.
  • At maturity you receive the inflation-adjusted principal or the original principal, whichever is greater.
  • TIPS can lose market value before maturity when interest rates rise; they’re best viewed as a long-term inflation hedge.
  • You can buy TIPS via TreasuryDirect, brokers, or through TIPS mutual funds and ETFs.

What are TIPS?

Treasury Inflation-Protected Securities (TIPS) are government bonds whose principal is adjusted for changes in the Consumer Price Index (CPI). They were created to help investors preserve purchasing power when prices rise. Interest is paid twice a year at a fixed rate, but the dollar amount of each payment changes because it’s calculated from the inflation-adjusted principal.

How TIPS work

  • Principal adjustment: Each TIPS issue’s principal rises with inflation (CPI) and falls with deflation, but at maturity you’ll receive at least the original principal.
  • Coupon payments: The fixed coupon rate is applied to the adjusted principal, so when inflation pushes principal higher your coupon payments increase.
  • Example: A $1,000 TIPS with a 1% coupon pays $10 annually if CPI doesn’t change. If CPI rises 2%, principal becomes $1,020 and the annual coupon is $10.20.
  • Market value risk: Like other bonds, TIPS prices fall when real interest rates rise, so they can lose value if sold before maturity.

Note: TIPS are intended as a long-term protection against rising living costs, not a short-term hedge against sudden inflation spikes.

Pros

  • Inflation protection: Principal and interest rise with CPI, helping preserve purchasing power.
  • Principal floor: At maturity you receive at least the original principal even after deflationary periods.
  • Safety: Backed by the U.S. government, so default risk is extremely low.
  • Semiannual income: Regular coupon payments that can increase with inflation.
  • State and local tax exemption: Interest is subject to federal tax but exempt from state and local income taxes.
  • Liquidity: Actively traded in secondary markets and available via funds/ETFs.

Cons

  • Lower nominal yields: TIPS generally have lower initial coupon rates than comparable nominal Treasuries because of their inflation protection.
  • Tax treatment of adjustments: The inflation-driven increases in principal are taxable as income in the year they occur, even though you don’t receive that cash until sale or maturity (this can create a phantom income tax liability).
  • Market-price risk: TIPS can decline in value when real interest rates rise, which can lead to losses if sold before maturity.
  • Not ideal in deflation: Principal adjusts downward with deflation (though the maturity floor protects principal).
  • Potential liquidity stress: In times of market stress liquidity can worsen and bid-ask spreads may widen.

Who should consider TIPS?

  • Retirees and near-retirees who depend on steady purchasing power for living expenses.
  • Conservative investors who prioritize capital preservation and inflation protection.
  • Long-term investors seeking a hedge against sustained inflation as part of a diversified portfolio.
  • Investors in high-tax states who value state/local tax exemption on interest (note federal tax still applies and inflation adjustments are taxable).

TIPS vs. nominal Treasury bonds

  • Nominal Treasuries pay fixed coupons and return the original principal at maturity; they do not adjust for inflation.
  • TIPS adjust principal with CPI, and coupons vary in dollar terms as principal changes.
  • TIPS protect real purchasing power; nominal Treasuries expose investors to inflation risk.

Yields and real yield concept

  • TIPS are quoted by real yield (yield above inflation). A TIPS real yield can be negative if expected inflation exceeds the nominal yield of comparable Treasuries.
  • Nominal yield minus expected inflation ≈ real yield. Even with a negative real yield, TIPS can offer inflation-adjusted principal growth that produces capital gains if actual inflation outpaces expected inflation.

Maturities

The U.S. Treasury currently issues TIPS with maturities of 5, 10, and 30 years.

How to buy TIPS

  • TreasuryDirect.gov: Buy new issues directly from the U.S. Treasury (minimum purchase typically $100).
  • Brokerages: Buy TIPS on the secondary market or participate in auctions through your broker.
  • Mutual funds and ETFs: Offer diversified exposure and ease of trading, but charge management fees and introduce fund-level tracking risks.
  • IRAs: TIPS and TIPS funds can be held inside IRAs via broker custodians (TreasuryDirect purchases can’t be held directly in an IRA).

Performance note

TIPS can underperform in environments of rising real interest rates. For example, during periods when central banks raise rates to fight inflation, TIPS market prices may fall even as principal adjustments occur. That’s why TIPS are most effective when held to maturity as part of a long-term inflation-protection strategy.

Bottom line

TIPS are a straightforward way to protect long-term purchasing power because their principal and coupon payments adjust with inflation. They’re best used by investors who need inflation protection and are willing to accept typically lower real yields and potential short-term market-price volatility. Consider tax implications of annual inflation adjustments and whether holding individual TIPS to maturity or using funds better fits your investment goals.