Inflation protected securities

What Is Inflation Protected Securities?

Inflation protected securities (IPS), commonly known as Treasury Inflation-Protected Securities (TIPS), are a type of Treasury securities issued by the U.S. government. These bonds are designed to shield investors from the negative effects of inflation, a sustained increase in the general price level of goods and services. Unlike conventional bonds, the principal of a TIPS is adjusted periodically to account for changes in the Consumer Price Index (CPI). As a category of fixed income products, TIPS aim to preserve an investor's purchasing power by ensuring that the return on investment keeps pace with rising living costs. While the coupon rate is fixed at issuance, the semi-annual interest payments fluctuate because they are paid on the inflation-adjusted principal. In periods of deflation, the principal can decrease, but it will not fall below the original par value at maturity.

History and Origin

The concept of linking bond payments to inflation has historical roots, with early instances noted in the Massachusetts Bay Colony during the American Revolutionary War to compensate soldiers for depreciating currency. However, the modern inflation-linked bond market originated in the United Kingdom in 1981. The United States officially introduced Treasury Inflation-Protected Securities in January 1997, with the first auction of a 10-year note¹³. The U.S. Treasury began issuing TIPS in response to strong market demand for an inflation-indexed asset class, seeking to reduce its long-term financing costs¹²,¹¹. Over time, the offerings expanded to include different maturities, such as 5-year, 10-year, and 30-year TIPS, though some maturities have been discontinued and reintroduced over the years¹⁰. The growth of the TIPS market has seen these securities become a significant component of the broader bond market.

Key Takeaways

• TIPS are U.S. government-issued bonds designed to protect investors from inflation.
• Their principal value adjusts with changes in the Consumer Price Index (CPI), directly impacting interest payments.
• At maturity, investors receive at least the original principal amount, even in periods of deflation.
• TIPS provide a guaranteed real yield, representing a return above inflation.
• They are a tool for preserving purchasing power in an investment portfolio.

Formula and Calculation

The principal value of a TIPS is adjusted based on the Consumer Price Index (CPI). The adjustment factor, known as the Index Ratio, is applied daily. The interest payment is then calculated on this adjusted principal.

The adjusted principal ( AP ) at any given time can be calculated as:

The semi-annual interest payment ( I ) is calculated as:

Where:

• ( AP ) = Adjusted Principal
• Original Principal = The face value of the bond at issuance (e.g., $1,000)
• Index Ratio = Current CPI divided by the CPI on the TIPS's issue date. This ratio reflects the cumulative inflation since the bond's inception.
• Coupon Rate = The fixed interest rate set at auction, applied to the adjusted principal.

For instance, if a TIPS has an initial principal of $1,000 and a 1% coupon rate, and the Index Ratio rises to 1.05 due to inflation, the adjusted principal becomes $1,050. The next semi-annual interest payment would then be calculated on this new $1,050 amount, rather than the original $1,000.

Interpreting the TIPS

Understanding TIPS involves focusing on their unique characteristics related to inflation. The key metric for TIPS is their real yield. Unlike nominal bonds, which offer a fixed interest payment regardless of inflation, TIPS provide a return that is in addition to the rate of inflation. A positive real yield means an investor earns a return above the increase in the Consumer Price Index (CPI).

Investors interpret the real yield as the true return on their investment after accounting for the erosion of purchasing power. When the market's expectation for future inflation rises, the real yield on TIPS may decrease relative to nominal bonds, as the inflation protection becomes more valuable. Conversely, if deflationary expectations set in, the real yield might rise. The difference between the yield of a nominal Treasury bond and a TIPS of the same maturity is often referred to as the "breakeven inflation rate," indicating the market's average annual inflation expectation over that period.

Hypothetical Example

Suppose an investor purchases a new 10-year TIPS with an original principal of $1,000 and a coupon rate of 0.50%.

Year 1:

• Initial Principal: $1,000
• Coupon Rate: 0.50%
• Assume inflation for the first six months (as measured by CPI) is 2%.
• Adjusted Principal after 6 months: $1,000 * (1 + 0.02) = $1,020.00
• First semi-annual interest payment: $1,020.00 * (0.0050 / 2) = $2.55

Year 2:

• Assume inflation for the next six months is 1.5%.
• The adjusted principal from the end of Year 1 ($1,020.00) is now further adjusted for this new inflation.
• Adjusted Principal after 12 months: $1,020.00 * (1 + 0.015) = $1,035.30
• Second semi-annual interest payment: $1,035.30 * (0.0050 / 2) = $2.58825 (rounded to $2.59)

This demonstrates how both the principal and subsequent interest payments on TIPS adjust upwards with inflation, helping to maintain the investor's original purchasing power.

Practical Applications

TIPS are primarily used by investors seeking to protect their portfolios from the adverse effects of rising inflation. They are a core component of asset allocation strategies for individuals and institutional investors who require predictable real returns, such as pension funds and endowments.

Investors can purchase TIPS directly from the U.S. government through the U.S. TreasuryDirect website in various maturities, typically 5-year, 10-year, and 30-year terms⁹,⁸. They can also be acquired through brokerage accounts in the secondary market, where existing bonds are traded⁷. These securities are also commonly found as underlying holdings in mutual funds and exchange-traded funds (ETFs) that specialize in inflation-protected bonds, providing an accessible way for investors to gain exposure. For individuals engaged in long-term financial planning, particularly for retirement, TIPS can be valuable for ensuring that future income streams retain their buying power. Their inclusion can contribute to overall portfolio diversification by providing a distinct asset class that behaves differently from traditional stocks and nominal bonds during inflationary periods.

Limitations and Criticisms

While TIPS offer unique inflation protection, they also have limitations. One potential drawback is that their yield can be lower than that of conventional Treasury bonds during periods of low inflation or deflationary expectations⁶. In a deflationary environment, the principal value of a TIPS will decrease, though it is guaranteed not to fall below its original par value at maturity⁵. However, if the bond is sold before maturity during a period of deflation, the investor could receive less than the original principal.

Another point of consideration for TIPS is their sensitivity to changes in real interest rates. Like all bonds, their market price can fluctuate based on movements in interest rates, which can impact returns if sold before maturity⁴. Additionally, some research suggests that TIPS may carry a "liquidity premium," meaning investors might accept a lower real yield compared to other assets due to the perceived ease of buying and selling them in the bond market, though liquidity can vary³,². Investor timing can also be a challenge, with some investors struggling to effectively use TIPS funds to capture their intended inflation protection¹.

Inflation Protected Securities vs. Nominal Bonds

The primary distinction between inflation protected securities (TIPS) and nominal bonds (also known as traditional Treasury bonds) lies in how they address inflation.

Confusion between the two often arises because both are issued by the U.S. Treasury and are considered very low-risk investments. However, TIPS are specifically structured to maintain purchasing power, while nominal bonds offer a fixed stream of income that may lose value in inflationary environments. The yield on a nominal bond typically includes an embedded expectation of future inflation, whereas the real yield on a TIPS is the return an investor receives in excess of actual inflation.

FAQs

How do TIPS protect against inflation?

TIPS protect against inflation by adjusting their principal value based on changes in the Consumer Price Index (CPI). If inflation rises, the principal increases, and subsequent interest payments (which are a fixed percentage of the principal) also increase, helping to preserve your purchasing power.

Can TIPS lose value?

Yes, TIPS can lose market value before maturity if real interest rates rise or if deflation occurs. While the principal is guaranteed not to fall below its original par value at maturity, selling before then could result in a loss if market conditions are unfavorable.

Where can I buy TIPS?

You can buy TIPS directly from the U.S. government through the U.S. TreasuryDirect website or through a brokerage account on the secondary market.

What is the difference between a TIPS and a traditional Treasury bond's yield?

The yield on a TIPS is a "real yield," meaning it represents the return an investor receives above the rate of inflation. The yield on a traditional Treasury bond is a nominal yield, which includes an expectation of inflation. The difference between the two yields on comparable maturities is often used to estimate the market's expected inflation rate.