What Are Treasury Inflation-Protected Securities (TIPS)?
Treasury Inflation-Protected Securities (TIPS) are a type of marketable fixed income security issued by the U.S. Treasury that are designed to protect investors from inflation. Unlike traditional bonds, the principal value of a TIPS is adjusted periodically based on changes in the Consumer Price Index (CPI), a widely used measure of inflation. This adjustment directly impacts both the bond's principal amount and its subsequent interest payments.
When inflation rises, the principal value of the TIPS increases, and conversely, it decreases during periods of deflation. The interest rate, also known as the coupon rate, on a TIPS is fixed at auction, but the actual interest payment received semi-annually will fluctuate because it is calculated based on the adjusted principal. At maturity, investors receive either the adjusted principal or the original principal, whichever is greater, guaranteeing that the original investment amount is protected against a decline in principal due to deflation.16
History and Origin
The concept of inflation-indexed bonds gained traction in various countries before their formal introduction in the United States. In the U.S., Treasury Inflation-Protected Securities were first issued in January 1997, following significant market interest in a security that could offer protection against rising prices.15 The inaugural auction featured a 10-year note, and within a year, both 5-year and 30-year TIPS were introduced to the market.14 The introduction of TIPS marked a significant development for investors seeking to preserve purchasing power, offering a government-backed option to hedge against inflation risk.
Key Takeaways
- TIPS are U.S. Treasury securities designed to protect against inflation.
- Their principal value adjusts with the Consumer Price Index (CPI).
- Interest payments, made semi-annually, are calculated on the inflation-adjusted principal.
- At maturity, investors receive the greater of the adjusted principal or the original principal.
- TIPS are generally considered low-risk investments due to being backed by the U.S. government.
Formula and Calculation
The principal value of a TIPS is adjusted monthly based on the non-seasonally adjusted Consumer Price Index for All Urban Consumers (CPI-U). The interest payment is then calculated by multiplying this adjusted principal by one-half of the fixed annual coupon rate.
To calculate the adjusted principal and subsequent interest payment:
-
Adjusted Principal Calculation:
Where:
- Original Principal = The face value of the TIPS at issuance (e.g., $1,000).
- Index Ratio = (\frac{\text{Reference CPI on Payment Date}}{\text{Reference CPI on Issue Date}}). The Consumer Price Index data is published monthly by the Bureau of Labor Statistics.12, 13
-
Interest Payment Calculation:
Where:
- Adjusted Principal = The current principal value after inflation adjustment.
- Coupon Rate = The fixed annual interest rate determined at the TIPS auction.
It is important to note that while the coupon rate is fixed, the actual dollar amount of the semi-annual interest payments will vary with the inflation-adjusted principal.
Interpreting Treasury Inflation-Protected Securities (TIPS)
The yield on a TIPS is often referred to as a "real yield" because it represents the return an investor receives above and beyond inflation. By comparing the yield on a TIPS to the yield on a nominal Treasury security of the same maturity, investors can infer the market's "breakeven inflation rate." This rate is the level of inflation at which the nominal bond and the TIPS would provide the same real return.
If actual inflation exceeds the breakeven rate, TIPS generally outperform nominal bonds, as the inflation adjustments provide a higher overall return. Conversely, if inflation comes in below the breakeven rate, nominal bonds may offer a better nominal return. Analysis of TIPS yields, especially in conjunction with nominal yields, can offer insights into market expectations for future inflation.10, 11
Hypothetical Example
Consider an investor who purchases a 10-year TIPS with an original principal of $1,000 and a fixed coupon rate of 0.50%.
In the first six months, assume the relevant CPI increases by 2%.
- Calculate the Index Ratio: If the CPI at issuance was 250 and it rises to 255 (a 2% increase), the index ratio would be (255 / 250 = 1.02).
- Adjust the Principal: The new adjusted principal would be ( $1,000 \times 1.02 = $1,020 ).
- Calculate the Semi-Annual Interest Payment: The interest payment for this period would be ( $1,020 \times (0.0050 / 2) = $2.55 ).
In the subsequent six-month period, if the CPI continues to rise, the adjusted principal would further increase, and the next interest payment would be calculated on this higher principal amount. If, however, there was a period of deflation, the principal would decrease, leading to smaller interest payments, though the investor is guaranteed to receive at least the original principal at maturity.
Practical Applications
Treasury Inflation-Protected Securities are widely used by investors seeking to protect their purchasing power against the eroding effects of inflation. They are a common component in portfolio diversification strategies, particularly for those concerned about long-term financial goals such as retirement planning.
TIPS are also a crucial tool for economists and policymakers. By analyzing the difference between the yield on a nominal Treasury security and a TIPS of comparable maturity, known as the breakeven inflation rate, market participants can gauge collective expectations about future inflation. The Federal Reserve, for instance, monitors these breakeven rates as part of its assessment of inflation expectations and the effectiveness of monetary policy.9 Investors can purchase TIPS directly from the U.S. government through TreasuryDirect, or via the secondary market through brokers.
Limitations and Criticisms
Despite their inflation-protection features, TIPS have certain limitations. One notable aspect is the taxation of "phantom income." The inflation adjustment to the principal of a TIPS is taxable in the year it occurs, even though the investor does not receive this portion of the return until the bond matures or is sold.7, 8 This can create a tax liability without an accompanying cash flow, potentially leading to liquidity issues for investors holding TIPS in taxable accounts. For this reason, many investors prefer to hold TIPS in tax-advantaged accounts, such as IRAs or 401(k)s.5, 6
Furthermore, the market value of TIPS can fluctuate based on changes in real interest rates, meaning they are not entirely immune to market risks. While they protect against inflation, a significant rise in real interest rates can cause the market price of TIPS to decline, even if inflation is stable or rising.4
Treasury Inflation-Protected Securities (TIPS) vs. Treasury Bonds
Treasury Inflation-Protected Securities (TIPS) and Treasury Bonds are both debt instruments issued by the U.S. Treasury, but their primary distinction lies in how they address inflation.
- Principal Adjustment: The most significant difference is that the principal of a TIPS adjusts with inflation (measured by the CPI), while the principal of a traditional Treasury Bond remains fixed at its face value.
- Interest Payments: Both securities pay semi-annual interest payments. However, the interest payments on TIPS fluctuate because they are applied to the inflation-adjusted principal, whereas traditional Treasury Bonds pay a fixed dollar amount of interest based on their fixed principal.
- Inflation Protection: TIPS are specifically designed to offer protection against inflation, ensuring that the purchasing power of the investment is preserved. Traditional Treasury Bonds do not offer this direct inflation protection; their real return can be eroded by rising prices.
- Maturity Payout: At maturity, a TIPS holder receives the greater of the original or inflation-adjusted principal. A traditional Treasury Bond holder receives only the original face value.
- Yield Interpretation: The yield on a TIPS is considered a real yield, reflecting a return above inflation, while the yield on a traditional Treasury Bond is a nominal yield, which includes an expectation of inflation.
FAQs
How often do TIPS adjust for inflation?
The principal value of TIPS is adjusted daily based on the Consumer Price Index (CPI), though the CPI itself is released monthly by the Bureau of Labor Statistics. These adjustments are then used to calculate the semi-annual interest payments.
Are TIPS tax-exempt?
No. Interest payments from TIPS are subject to federal income tax, though they are exempt from state and local income taxes. Additionally, the annual inflation adjustments to the principal are also taxable as ordinary income in the year they occur, which is often referred to as "phantom income."2, 3
Can TIPS lose money?
While TIPS protect your original principal against inflation and deflation (you'll never receive less than your original principal at maturity), their market value can fluctuate before maturity. If you sell a TIPS on the secondary market before it matures, its price could be lower than what you paid, resulting in a loss. This fluctuation is primarily driven by changes in real interest rates.
What is the minimum investment for TIPS?
TIPS can typically be purchased in increments of $100, with a minimum investment of $100.
How do TIPS differ from I Bonds?
Both TIPS and I Bonds are U.S. Treasury securities that offer inflation protection. However, TIPS are marketable securities with a fixed coupon rate and an inflation-adjusted principal, and their market value can fluctuate. I Bonds have a fixed rate and a variable inflation rate, are non-marketable (cannot be sold on a secondary market), and their interest accrues and is paid at redemption, allowing for tax deferral until the bond is cashed or matures.1