Treasury Inflation-Protected Securities — commonly called TIPS — were first made available in 1997 as a way to give investors a bond that keeps pace with rising prices. Unlike traditional bonds, which deliver returns in dollar terms without accounting for inflation, TIPS are specifically structured to act as a shield against the eroding effects of inflation on purchasing power.
These are bonds issued directly by the US Treasury, available with maturity periods of five, 10, or 30 years. They pay a fixed interest rate every six months, but the actual dollar amount of those payments can shift because it depends on the bond’s current principal value, which itself changes with inflation.
Every six months, the Treasury recalculates the principal using the Consumer Price Index. When inflation rises, the principal goes up accordingly.
When an investor holds a TIPS bond all the way to maturity, they receive whichever is larger — the inflation-adjusted principal or the original principal amount they started with.
Over longer stretches of time, TIPS have managed to stay ahead of inflation. They have also outperformed other investment-grade bonds across most maturity ranges.
However, that performance comes with greater price swings.
Looking at the 20-year period ending May 31, TIPS with maturities of 10 years or longer have experienced price volatility nearly double that of shorter-term TIPS in the five-to-10-year range — and with lower returns to show for it.
The core reason for this is interest rate sensitivity. Like all bonds, TIPS lose principal value when interest rates climb. That loss may or may not be offset by inflation adjustments happening at the same time. Because TIPS issuance has historically leaned toward longer-term bonds, most TIPS benchmarks carry longer durations, making them especially exposed to interest rate swings.
In the most extreme cases, TIPS with maturities of 10 years or more have dropped by as much as 41% when interest rates surged sharply.
During the so-called taper tantrum of 2013, when interest rates spiked, TIPS fell far more than other investment-grade bonds. And during the global financial crisis in September and October 2008, limited liquidity became a serious problem, with TIPS shedding nearly 12% of their value.
There are several ways investors can get exposure to TIPS.
One approach is buying an individual TIPS bond directly through TreasuryDirect or a standard brokerage account.
Another strategy is building a TIPS ladder — a collection of bonds with staggered maturity dates. For instance, a retiree could purchase 30 separate sets of TIPS maturing at one-year intervals over the next 30 years. The interest payments and proceeds from maturing bonds can then be used to cover living expenses year by year.
TIPS mutual funds or ETFs offer a simpler path since they don’t require selecting individual bonds, though they don’t provide the same precise cash flow matching that a ladder does.
iShares now offers a lineup of target-maturity TIPS ETFs with maturity dates extending out to 2036.
For those investing through a TIPS fund, Morningstar recommends choosing one with a short- or intermediate-term maturity and planning to hold it for at least two to six years, in line with Morningstar’s Role in Portfolio Framework.
For individual TIPS bonds, the key is matching the bond’s maturity date to when you’ll actually need the money. Even though the principal value will fluctuate in the meantime, interest rate risk becomes a non-issue if you hold the bond through to maturity.
Younger investors may not need TIPS at all. Their biggest asset is often human capital — the total future earnings they expect to generate over a working lifetime. Since wages typically rise alongside inflation, this built-in adjustment already serves as a natural hedge. Add to that the fact that younger investors tend to hold more stocks, which are among the most effective long-term tools for combating inflation.
For investors approaching or already in retirement, the case for TIPS is stronger. Fixed-income holdings become more vulnerable to inflation, and an inflation hedge takes on greater importance. According to Morningstar’s Lifetime Allocation Indexes, putting 20% to 40% of a portfolio’s fixed-income holdings into TIPS is a reasonable target.
Retirees who build a TIPS ladder to fund their spending should be aware that such a strategy is designed to wind down to zero. A 30-year ladder, for example, will have no remaining balance at the end of year 30. Those worried about outliving their money or hoping to leave assets to heirs should keep additional investments outside the ladder to meet those needs.
One more important consideration: both the interest payments and any increases in TIPS principal are taxed as ordinary income. For that reason, TIPS are generally best held inside a tax-sheltered account like an IRA.
Finally, TIPS are not always a worthwhile addition to a portfolio. There have been periods when they offered negative real yields, meaning investors would actually lose spending power over time even after accounting for the inflation adjustment.
This article was provided to The Associated Press by Morningstar. Amy C. Arnott, CFA, is a portfolio strategist for Morningstar and co-host of The Long View podcast.
