Tips

What Are Treasury Inflation-Protected Securities (TIPS)?

Treasury Inflation-Protected Securities (TIPS) are a type of U.S. Treasury security designed to protect investors from the erosive effects of inflation. As a key component of the fixed income asset class, TIPS offer a way to preserve purchasing power over time. Unlike conventional Treasury Bonds, the principal value of a TIPS bond is adjusted periodically based on changes in a recognized inflation gauge, such as the Consumer Price Index (CPI). This adjustment directly impacts both the bond's principal and its interest payments, ensuring the investor's real return is maintained, or at least cushioned, against rising prices.

History and Origin

The concept of inflation-indexed bonds emerged in various forms throughout history, often in response to periods of high inflation. However, the modern iteration of Treasury Inflation-Protected Securities was introduced relatively recently. The U.S. Treasury first auctioned TIPS in January 1997, marking a significant development in government debt instruments aimed at offering direct inflation protection to investors.⁶ Their introduction provided a new tool for investors to hedge against the uncertainty of future price increases, a concern that had gained prominence following inflationary periods in previous decades.

Key Takeaways

• TIPS are U.S. Treasury securities whose principal value adjusts with inflation or deflation.
• Interest payments on TIPS are paid semi-annually and fluctuate with the adjusted principal amount.
• At maturity, investors receive either the adjusted principal or the original principal, whichever is greater, offering a form of principal protection.
• TIPS are a component of fixed income portfolios, often used for portfolio diversification against inflation risk.

Formula and Calculation

The calculation for TIPS involves two main components: the inflation-adjusted principal and the semi-annual interest payment.

1. Inflation-Adjusted Principal: The original principal amount of a TIPS bond is indexed to the Consumer Price Index (CPI). This adjustment occurs daily.
   Let ( P_0 ) be the original principal and ( CPI_{current} ) be the current CPI, and ( CPI_{issue} ) be the CPI at the time of issuance.
   The adjusted principal ( P_t ) at time ( t ) is calculated as:
   $P_t = P_0 \times \frac{CPI_{current}}{CPI_{issue}}$

2. Semi-Annual Interest Payment: TIPS pay a fixed coupon rate that is determined at auction. This fixed rate is then applied to the adjusted principal amount, not the original principal. Therefore, the dollar amount of the interest payments can fluctuate.
   Let ( CR ) be the fixed coupon rate.
   The semi-annual interest payment ( I_t ) is calculated as:
   $I_t = P_t \times \frac{CR}{2}$
   If inflation rises, ( P_t ) increases, leading to higher interest payments. Conversely, if deflation occurs, ( P_t ) decreases, resulting in lower interest payments.

Interpreting the TIPS

Interpreting TIPS involves understanding their real return and how they function as an inflation hedge. The yield on a TIPS bond, often referred to as its real yield, represents the return an investor can expect above the rate of inflation. For example, a TIPS with a 0.5% real yield indicates that the investment is expected to return 0.5% more than the rate of inflation over its life.

When the real yield of TIPS is positive, it suggests that the bond will provide a positive return even after accounting for inflation. A negative real yield, while seemingly counterintuitive, can occur in periods of high demand for inflation protection or when investors anticipate very low or negative real return from other low-risk assets. The effectiveness of TIPS lies in their ability to maintain purchasing power, making them distinct from Nominal Bonds that offer fixed nominal returns.

Hypothetical Example

Consider an investor purchasing a newly issued 10-year TIPS bond with a principal of $1,000 and a fixed coupon rate of 0.25%.
At the time of issuance, let the Consumer Price Index (CPI) be 200.

Scenario 1: Inflation
One year later, assume inflation causes the Consumer Price Index (CPI) to rise to 206.

• Adjusted Principal: The principal adjusts: ( $1,000 \times \frac{206}{200} = $1,030 ).
• Semi-Annual Interest Payment: The coupon rate is applied to the new principal: ( $1,030 \times \frac{0.0025}{2} = $1.2875 ).
  Over the year, the investor receives two such interest payments, totaling $2.575. The effective principal has also increased to $1,030.

Scenario 2: Deflation
Alternatively, if deflation occurs and the Consumer Price Index (CPI) falls to 198 after one year.

• Adjusted Principal: The principal adjusts downward: ( $1,000 \times \frac{198}{200} = $990 ).
• Semi-Annual Interest Payment: The coupon rate is applied to the new principal: ( $990 \times \frac{0.0025}{2} = $1.2375 ).
  In this case, the interest payments would be lower, and the adjusted principal would be less than the original $1,000. However, at maturity, the U.S. Treasury guarantees to return no less than the original $1,000 principal amount.

Practical Applications

Treasury Inflation-Protected Securities are widely used by investors seeking to mitigate inflation risk within their portfolios. They are particularly attractive to individuals and institutions with long-term liabilities sensitive to rising costs, such as pension funds or retirees.

Common applications include:

• Retirement Planning: TIPS can help preserve the purchasing power of retirement savings, ensuring that future expenses, which are likely to increase with inflation, can still be met.
• Portfolio Diversification: By offering protection against unexpected inflation, TIPS can serve as a diversifying asset, particularly when traditional fixed income securities might underperform in inflationary environments. This contributes to a robust asset allocation strategy.
• Inflation Expectations Indicator: The difference between the yield on a nominal Treasury bond and a TIPS bond of comparable maturity (known as the "breakeven inflation rate") can serve as a market-implied measure of future inflation expectations. Market participants and policymakers often monitor these rates as an economic indicator.
• Central Bank Holdings: Central banks, including the Federal Reserve, hold significant amounts of U.S. Treasury securities, which may include TIPS, as part of their open market operations and to manage their balance sheets. The Federal Reserve publishes weekly data on its holdings, including inflation compensation on TIPS.⁵

Data for the Consumer Price Index (CPI), which directly impacts TIPS adjustments, is regularly published by the U.S. Bureau of Labor Statistics.⁴

Limitations and Criticisms

While Treasury Inflation-Protected Securities offer distinct advantages, they also come with certain limitations and criticisms that investors should consider:

• Deflation Risk: Although TIPS provide protection against inflation, their principal value can be adjusted downward in a deflationary environment, reducing the bond's overall market value and interest payments during its term. While the U.S. Treasury guarantees to return no less than the original principal at maturity, this protection does not apply to the bond's market value before maturity.
• Taxation of "Phantom Income": One notable drawback is that the annual increases in the principal due to inflation adjustments are considered taxable income by the IRS in the year they occur, even though investors do not receive this amount until the bond matures or is sold. This "phantom income" means investors may owe taxes on gains they have not yet realized in cash.
• Lower Yields in Low-Inflation Environments: TIPS typically offer a lower yield compared to comparable conventional Treasury Bonds in periods of low inflation or when inflation expectations are subdued. This lower initial yield is the price paid for the embedded inflation protection.³
• Interest Rate Risk: Like all bonds, TIPS are subject to interest rate risk. If nominal interest rates rise significantly due to factors other than inflation (e.g., changes in monetary policy or economic growth expectations), the market value of existing TIPS can decline.¹, ²
• Liquidity: While generally liquid, the secondary market for TIPS may be less liquid than that for conventional Treasury Bonds during times of market stress, potentially leading to wider bid-ask spreads.

Treasury Inflation-Protected Securities (TIPS) vs. Nominal Bonds

Treasury Inflation-Protected Securities (TIPS) and Nominal Bonds are both debt instruments issued by the U.S. Treasury, but their primary difference lies in how they address inflation.

Confusion often arises because both are considered low-risk U.S. government debt. However, their distinct mechanisms for handling inflation mean they behave differently in various economic environments, appealing to investors with differing objectives regarding inflation risk management.

FAQs

What is the main purpose of TIPS?

The main purpose of Treasury Inflation-Protected Securities (TIPS) is to safeguard an investor's purchasing power against the effects of inflation. By adjusting their principal value with changes in the Consumer Price Index (CPI), TIPS aim to provide a more predictable real return than conventional bonds.

How do TIPS adjust for inflation?

TIPS adjust for inflation by increasing their principal value when the Consumer Price Index (CPI) rises. This adjusted principal then determines the semi-annual interest payments. If deflation occurs, the principal is adjusted downward, but at maturity, the investor receives no less than the original principal.

Can TIPS have a negative yield?

Yes, TIPS can have a negative yield. A negative real yield means that the bond's return after accounting for inflation is expected to be negative. This can happen during periods of very high demand for inflation protection, causing bond prices to rise and yields to fall, or when market participants anticipate very low or negative real return from other low-risk investments.

Are TIPS risk-free?

While TIPS are backed by the full faith and credit of the U.S. government, making them nearly free of default risk, they are not entirely without risk. They are subject to interest rate risk (their market value can fluctuate with interest rate changes) and deflation risk (their principal can be adjusted downward in a deflationary environment before maturity).

How can I buy TIPS?

Individual investors can purchase TIPS directly from the U.S. Treasury through the TreasuryDirect system. Alternatively, TIPS can be bought through brokers in the secondary market, or indirectly through mutual funds and exchange-traded funds (ETFs) that specialize in inflation-protected securities.