What Are Treasury Inflation-Protected Securities?
Treasury Inflation-Protected Securities, commonly known as TIPS, are a type of U.S. Treasury bond designed to protect investors from the corrosive effects of inflation. As a key component of the broader fixed-income category of investments, TIPS offer a unique feature: their principal value adjusts in response to changes in the Consumer Price Index (CPI), the most common measure of inflation24, 25. This adjustment ensures that the purchasing power of an investor's principal is preserved over time. Unlike conventional bonds, where the principal remains static, the principal of a TIPS can increase during periods of inflation or decrease during periods of deflation. However, at maturity date, investors are guaranteed to receive no less than their original principal23.
History and Origin
Treasury Inflation-Protected Securities were first introduced by the U.S. Treasury in January 199721, 22. The aim was to provide investors with a security that could explicitly hedge against inflation risk, a feature not inherently available in traditional government bonds. The decision to issue these inflation-indexed securities was also driven by a desire to potentially reduce the U.S. Treasury's long-term financing costs by appealing to a broader base of investors seeking inflation protection20. Initially offered in various maturities, including 5, 10, and 30 years, TIPS quickly became an established part of the U.S. government's debt offerings18, 19.
Key Takeaways
- Treasury Inflation-Protected Securities (TIPS) are U.S. Treasury bonds designed to protect investors from inflation.
- The principal value of a TIPS adjusts upward with inflation and downward with deflation, based on the Consumer Price Index (CPI).
- TIPS pay a fixed coupon rate, but the actual interest payments fluctuate because they are applied to the inflation-adjusted principal.
- At maturity, investors receive either the inflation-adjusted principal or the original principal, whichever is greater, providing a principal guarantee.
- TIPS can be purchased directly from TreasuryDirect or through brokerage firms.
Formula and Calculation
The principal value of a Treasury Inflation-Protected Security is adjusted periodically based on the Consumer Price Index for All Urban Consumers (CPI-U). The interest payment is then calculated based on this adjusted principal.
The adjusted principal ((AP)) at any given time can be calculated as:
Where:
- (AP) = Adjusted Principal
- (OP) = Original Principal (Par Value)
- (CPI_{current}) = Consumer Price Index at the current date
- (CPI_{issue}) = Consumer Price Index at the bond's issue date
The semi-annual interest payment ((I)) is then determined by:
This means that as the principal increases with inflation, the dollar amount of the semi-annual interest payment also increases, reflecting the rise in the cost of living. Conversely, in a period of deflation, the principal and subsequent interest payments would decrease.
Interpreting Treasury Inflation-Protected Securities
Interpreting Treasury Inflation-Protected Securities primarily involves understanding their real return and how they reflect market expectations for inflation. Unlike traditional bonds that offer a nominal return, TIPS provide a return that is adjusted for inflation, effectively preserving the investor's purchasing power. The stated coupon rate on a TIPS is its real yield at issuance.
The difference between the yield of a conventional Treasury bond and a TIPS of the same maturity is known as the "breakeven inflation rate"16, 17. This rate represents the average annual inflation rate over the bond's life at which the total return of the TIPS would equal that of the conventional Treasury bond. If actual inflation turns out to be higher than this breakeven rate, TIPS will generally outperform conventional Treasuries. Conversely, if inflation is lower than the breakeven rate, conventional Treasuries may offer a better return. This breakeven rate is a market-derived indicator of investor expectations for future inflation15.
Hypothetical Example
Imagine an investor purchases a newly issued 5-year Treasury Inflation-Protected Security with an original principal of $1,000 and a fixed coupon rate of 0.50%. The CPI at the time of issue is 200.
After one year, suppose the CPI increases by 3% to 206.
-
Calculate the new adjusted principal:
(AP = $1,000 \times \frac{206}{200} = $1,000 \times 1.03 = $1,030) -
Calculate the semi-annual interest payment:
The interest payments are made on the adjusted principal. Since the coupon rate is 0.50% annually, the semi-annual rate is 0.25%.
First semi-annual payment: (I = $1,030 \times 0.0025 = $2.575)
Second semi-annual payment: (I = $1,030 \times 0.0025 = $2.575)
Total annual interest payment for that year: $5.15
This example illustrates how both the principal and subsequent interest payments on the TIPS adjust upwards, maintaining the investor's purchasing power in an inflationary environment. If the investor held this TIPS to its maturity date and the CPI continued to rise, they would receive the higher, inflation-adjusted principal at the end of the term.
Practical Applications
Treasury Inflation-Protected Securities serve several practical applications within an investment portfolio and broader economic analysis. Their primary use is as a hedge against unexpected inflation. Investors looking to preserve the purchasing power of their capital, especially those nearing or in retirement, often incorporate TIPS into their portfolios to ensure their future income and savings are not eroded by rising prices.
TIPS are also used by institutional investors and central banks to gauge market expectations for future inflation. The difference in yield between a nominal Treasury bond and a TIPS of the same maturity provides insights into what market participants anticipate inflation will be over that period14. This "breakeven inflation rate" is closely watched by economists and policymakers, including the Federal Reserve, as it reflects investor sentiment regarding price stability. Data on real yields and inflation compensation from the U.S. Treasury and the Federal Reserve Bank of San Francisco are publicly available and frequently analyzed for these purposes12, 13.
Limitations and Criticisms
Despite their inflation-protection benefits, Treasury Inflation-Protected Securities have certain limitations and criticisms. One significant concern is the "phantom income" issue9, 10, 11. While the principal of a TIPS adjusts with inflation, the increase in principal is considered taxable income by the Internal Revenue Service in the year it occurs, even though the investor does not receive this cash until the bond matures or is sold8. This can lead to a tax liability without a corresponding cash distribution, which is particularly problematic for investors holding TIPS in taxable accounts. Many financial professionals suggest holding TIPS in tax-advantaged accounts, such as IRAs or 401(k)s, to defer this tax burden7.
Another limitation is their performance during periods of deflation. While the principal of a TIPS is guaranteed not to fall below its original par value at maturity, it can decrease during deflationary periods, leading to lower interest payments and potential market value losses if sold before maturity5, 6. Furthermore, like all bonds, TIPS are subject to interest rate risk. If real interest rates rise, the market value of existing TIPS can fall, even if inflation is positive3, 4. Therefore, while they protect against inflation, they do not eliminate all investment risks.
Treasury Inflation-Protected Securities vs. Treasury Bonds
Treasury Inflation-Protected Securities (TIPS) and Treasury bonds are both debt instruments issued by the U.S. government, making them among the safest investments in terms of credit risk. However, their core functionality and how they interact with inflation differ significantly.
The primary distinction lies in how they handle inflation. Treasury bonds pay a fixed nominal return, meaning their coupon payments and principal repayment are set at the time of issuance and do not change with inflation. Consequently, if inflation rises unexpectedly, the purchasing power of the fixed payments from a Treasury bond erodes. In contrast, TIPS are specifically designed to protect against inflation. Their principal value is adjusted by the Consumer Price Index, and their interest payments are calculated based on this inflation-adjusted principal. This means that as inflation rises, both the principal and the dollar amount of interest payments from a TIPS increase, preserving the investor's real return. Conversely, during periods of deflation, the principal of a TIPS would decrease, though it is guaranteed not to fall below its original par value at maturity. Treasury bonds do not offer this inflation adjustment.
FAQs
How are Treasury Inflation-Protected Securities taxed?
The interest payments on Treasury Inflation-Protected Securities are taxed as ordinary income. Additionally, the adjustments made to the principal due to inflation are also considered taxable income in the year they occur, even though the investor does not receive this money until the bond matures or is sold. This "phantom income" can be a drawback, leading some investors to hold TIPS in tax-advantaged accounts like IRAs to defer taxation.
Can Treasury Inflation-Protected Securities lose money?
Yes, while the principal of a TIPS is guaranteed not to fall below its original amount at maturity date, their market value can fluctuate before maturity. If real interest rates rise, the price of existing TIPS can fall. Also, in periods of deflation, the principal value and subsequent interest payments will decrease, which could lead to losses if the bond is sold before maturity.
Where can I buy Treasury Inflation-Protected Securities?
Treasury Inflation-Protected Securities can be purchased directly from the U.S. government through the TreasuryDirect website2. They are also available for purchase through banks, brokers, and dealers, often as individual bonds or through mutual funds and exchange-traded funds (ETFs) that invest in inflation-linked securities.
What is the "real yield" of a TIPS?
The "real yield" of a TIPS is the stated coupon rate at which it is issued, representing the actual return an investor can expect above the rate of inflation. It is distinct from the nominal yield of a traditional bond because it already accounts for inflation protection. The daily real yield curve for TIPS is published by the U.S. Treasury1.