What Are Treasury Inflation-Protected Securities (TIPS)?
By Rebecca Lake  Inflation, or a sustained period of rising consumer prices, can take a bite out of investor portfolios and reduce purchasing power as the prices of goods and services increase. Treasury Inflation-Protected Securities, or TIPS, are one way to hedge against inflation in a portfolio. These government-issued securities are inflation-protected bonds that adjust in tandem with shifts in consumer prices to maintain value. Investing in TIPS bonds could make sense for investors who are seeking protection against inflation or who want to increase their conservative asset allocation. This primer answers those questions and more. Understanding Treasury Inflation-Protected Securities starts with understanding a little about how bonds work. When you invest in a bond, whether its issued by a government, corporation or municipality, youre essentially lending the issuer your money. In return, the bond issuer agrees to pay that money back to you at a specified date, along with interest. For that reason, bonds are often a popular option for those seeking fixed income investments. TIPS are inflation-protected bonds that pay interest out to investors twice annually, at a fixed rate applied to the adjusted principal of the bond. This principal can increase with inflation or decrease with deflation, which is a sustained period of falling prices. When the bond matures, youre paid out the original principal or the adjusted principalwhichever is greater. Here are some key TIPS basics to know:   TIPS bonds are issued in terms of 5, 10 and 30 years   Interest rates are determined at auction   Minimum investment is $100   TIPS are issued electronically   You can hold TIPS bonds until maturity or sell them ahead of the maturity date on the secondary market  Treasury Inflation-Protected Securities are different from other types of government-issued bonds. With I Bonds, for example, interest accrues over the life of the bond and is paid out when the bond is redeemed. Interest earned is not based on any adjustments to the bond principalhence, no inflationary protection. How Treasury Inflation Protected Securities (TIPS) Work  Understanding how TIPS work is really about understanding the relationship they have with inflation and deflation. Inflation refers to an increase in the price of goods and services over time. The federal government measures inflation using price indexes, including the Consumer Price Index. The federal government measures inflation using the Consumer Price Index, which measures the average change in prices over time for a basket of consumer goods and services. That includes things like food, gas, and energy or utility services. Deflation is essentially the opposite of inflation, in which consumer prices for goods and services drop over time. This can happen in a recession, but deflation can also be triggered when theres a significant imbalance between supply and demand for goods and services. Both inflation and deflation can be detrimental to investors if they have trickle-down effects that impact the way consumers spend and borrow money. When inflation or deflation occurs, inflation-protected bonds can provide a measure of stability with regard to investment returns. Heres how it works:   You purchase one or more Treasury Inflation-Protected Securities   You then earn a fixed interest rate on the TIPS bond you own   When inflation increases, the bond principal increases   When deflation occurs, the bond principal decreases   Once the bond matures, you receive the greater of the adjusted principal or the original principal  This last part is what protects you from negative impacts associated with either inflation or deflation. Youll never receive less than the face value of the bond, since the principal adjusts to counteract changes in consumer prices. Investing in inflation-protected bonds could make sense if youre interested in creating some insulation against the impacts of inflation in your portfolio. For example, say you invest $1,000 into a 10-year TIPS bond that offers a 2% coupon rate. The coupon rate represents the yield or income you can expect to receive from the bond while you hold it. Now, assume that inflation rises to 3% over the next year. This would put the bonds face value at $1,030, with an annual interest payment of $20.60. If you were looking at a period of deflation instead, then the bonds face value and interest payments would decline. But the principal would adjust to reflect that to minimize the risk of a negative return. Recommended: Understanding Deflation and How it Impacts Investors  Pros of Investing in TIPS  What TIPS offer that more traditional bonds dont is a real rate of return versus a nominal rate of return. In other words, the interest you earn with Treasury Inflation Protected Securities reflects the bonds actual return once inflation is factored in. As mentioned, I Bonds dont offer that; youre just getting whatever interest is earned on the bond over time. Since these are government bonds, theres virtually zero credit risk to worry about. (Credit risk means the possibility that a bond issuer might default and not pay anything back to investors.) With TIPS bonds, youre going to at least get the face value of the bond back if nothing else. And compared to stocks, bonds are generally a far less risky investment. If the adjusted principal is higher than the original principal, then you benefit from an increase in inflation. Since its typically more common for an economy to experience periods of inflation rather than deflation, TIPS can be an attractive diversification option if youre looking for a more conservative investment. Recommended: The Importance of Portfolio Diversification  Cons of Investing in TIPS  There are some potential downsides to keep in mind when investing with TIPS. For example, theyre more sensitive to interest rate fluctuations than other types of bonds. If you were to sell a Treasury Inflation-Protected Security before it matures, you could risk losing money, depending on the interest rate environment. You may also find less value from holding TIPS in your portfolio if inflation doesnt materialize. When you redeem your bonds at maturity you will get back the original principal and youll still benefit from interest earned. But the subsequent increases in principal that TIPS can offer during periods of inflation is a large part of their appeal. Its also important to consider where taxes fit in. Both interest payments and increases in principal from inflation are subject to federal tax, though they are exempt from state and local tax. The better your TIPS bonds perform, the more you might owe in taxes at the end of the year. How to Invest in Treasury Inflation Protected Securities  If youre interested in adding TIPS to your portfolio, there are three ways you can do it. 1. Purchase TIPS bonds directly from the U.S. Treasury. You can do this online through the TreasuryDirect website. Youd need to open an account first but once you do so, you can submit a noncompetitive bid for inflation protected bonds. The TreasuryDirect system will prompt you on how to do this. 2. Purchase TIPS through a banker, broker or dealer. With this type of arrangement, the banker, broker or dealer submits a bid for you. You can either specify what type of yield youre looking for, which is a competitive bid, or accept whatever is available, which is a noncompetitive bid. 3. Invest in securities that hold TIPS, i.e. exchange-traded funds or mutual funds. Theres no such thing as a TIP stock but you could purchase a TIPS ETF if youd like to own a basket of Treasury Inflation-Protected Securities. You might choose this option if you dont want to purchase individual bonds and hold them until maturity. When comparing different types of investments that are available with ETFs or mutual funds, pay attention to:   Underlying holdings   Fund turnover ratio   Expense ratios  Also consider the funds overall performance, particularly during periods of inflation or deflation. Past history is not an exact predictor of future performance but it may shed some light on how a TIPS ETF has reacted to rising or falling prices previously. The Takeaway  Treasury Inflation-Protected Securities may help shield your portfolio against some of the negative impacts of inflation. Investors who are worried about their purchasing power shrinking over time may find TIPS appealing. But dont discount the value of investing in stocks and other securities as well. Building a diversified portfolio that takes into consideration an investors personal risk tolerance, as well as financial goals and time horizons, is a popular strategy. With a SoFi Invest online investing account, members can choose from stocks, ETFs, and cryptocurrency options in one place. You can start investing with as little as $1, and manage your account from the convenient mobile app.