Jan. 4, 2025

How Do TIPS Work to Protect Your Retirement Portfolio Against Inflation?

Treasury Inflation-Protected Securities (TIPS): A Comprehensive Guide

Inflation can be a significant threat to long-term investment goals, diminishing the purchasing power of savings over time. This is especially true for fixed-income securities like bonds, which offer a fixed income stream that rising prices can erode. Treasury Inflation-Protected Securities (TIPS) offer a solution to this challenge by providing investors with a way to maintain their purchasing power in the face of inflation. This comprehensive guide explores how TIPS Work to Protect Your Retirement Portfolio Against Inflation and tackles disadvantages, historical performance, current yields, tax treatment, and how to purchase them.

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What are Treasury Inflation-Protected Securities (TIPS)?

Inflation is an increase in the price of goods and services, effectively reducing the value of money¹. To combat this, the U.S. Treasury issued Treasury Inflation-Protected Securities (TIPS), a special type of bond designed to protect investors from the erosion of purchasing power caused by inflation². Unlike traditional bonds with a fixed principal, the principal value of a TIPS adjusts with changes in the Consumer Price Index (CPI), a key measure of inflation². As inflation rises, the principal value of TIPS is adjusted upwards, and when inflation falls, the principal is adjusted downwards².

TIPS pay interest twice a year at a fixed rate. However, since the principal amount on which the interest is calculated can change, the actual dollar amount of the interest payments will vary². At maturity, TIPS investors receive the adjusted principal or the original principal, whichever is greater³. This key feature ensures that investors will never receive less than their initial investment, even if deflation occurs⁴.

Advantages of Investing in TIPS

TIPS offer several advantages for investors seeking to protect their portfolios from inflation and achieve their financial goals:

Inflation Protection: The most significant benefit of TIPS is their ability to safeguard investments from the erosive effects of The principal adjusts with the CPI, ensuring that the investment's value keeps pace with rising prices⁵. This inflation protection is not available in most other fixed-income investments⁶.
Guaranteed Real Return: Unlike traditional bonds that offer a "nominal" return—a fixed interest rate that does not account for inflation—TIPS provide a "real" This means that the return on TIPS is adjusted for inflation, ensuring that the investor's purchasing power is maintained over time¹. For example, if a traditional bond pays a 5% return and inflation is 3%, the real return is only 2%. With TIPS, the principal and interest payments are adjusted upwards with inflation, providing a return that reflects the true increase in purchasing power.
Safety and Stability: TIPS are backed by the full faith and credit of the S. government, making them a low-risk investment with minimal risk of default³.
Regular Interest Payments: TIPS provide semi-annual interest payments, offering investors a predictable stream of income³.
Tradable on an Exchange: TIPS can be bought and sold in the secondary market, providing liquidity for investors who may need to access their funds before maturity⁵. However, it's important to note that there is no guarantee that an investor will be able to sell TIPS at the price they paid, especially during times of market volatility.
Tax Advantages: The interest income from TIPS is exempt from state and local taxes⁵.
Portfolio Diversification: TIPS have a low correlation with other asset classes, such as stocks and traditional This means that their prices tend to move independently, which can help reduce overall portfolio volatility¹.

Disadvantages of Investing in TIPS

While TIPS offer valuable inflation protection and other benefits, investors should also be aware of their potential drawbacks:

Lower Yields Compared to Other Bonds: TIPS generally offer lower yields compared to other types of bonds, particularly in low-inflation environments³. This is because the market factors the cost and potential benefit of inflation into the fixed interest rate of TIPS⁵. In other words, investors are willing to accept a lower yield in exchange for the inflation protection that TIPS provide.
Taxation of Inflation Adjustments: The increase in principal due to inflation adjustments is considered taxable income in the year it occurs, even though the investor does not receive this income until maturity or sale³. This can create a tax liability even when the investor has not received any cash flow.
Interest Rate Risk: Like all bonds, TIPS are subject to interest rate risk¹. If interest rates rise, the price of TIPS may decline in the secondary market, even though the principal is adjusted for inflation. This is because investors may be able to find other investments with higher yields, making existing TIPS less attractive.
Deflation Risk: While TIPS protect against inflation, they may underperform during periods of deflation. If the CPI decreases, the principal value of TIPS is adjusted downward, potentially reducing the overall return³. However, it's important to remember that investors will still receive their original principal at maturity, even if deflation has occurred.
Liquidity Issues: Although TIPS are generally liquid, they may become less so during times of financial crisis or market stress³. This means that it may be more difficult to sell TIPS quickly at a fair price during periods of market turmoil.
CPI May Understate Inflation: TIPS are linked to the CPI, which may not accurately reflect the actual inflation experienced by individual consumers⁵. This is because the CPI is a broad measure of inflation that may not perfectly capture the price changes of specific goods and services that individual consumers purchase.
No Guarantee of Inflation-Adjusted Return in Mutual Funds: While individual TIPS guarantee an inflation-adjusted return if held to maturity, this is not the case for TIPS held within a mutual fund¹. A fund manager may buy or sell TIPS before maturity, which could lead to gains or losses that deviate from the inflation-adjusted return of the underlying TIPS.

Historical Performance of TIPS

The performance of TIPS has varied over time, depending on factors such as inflation expectations, interest rate movements, and investor demand. When inflation is relatively stable and close to the Federal Reserve's target, TIPS have generally underperformed nominal Treasury bonds⁹. This is because investors are essentially paying a premium for inflation protection that may not be fully realized in a low-inflation environment. However, when inflation rises significantly above the Fed's target, TIPS have outperformed nominal Treasuries⁹.

For example, from December 31, 2021, through November 15, 2024, the Bloomberg US TIPS Index lost more than 6% due to rising interest rates¹⁰. However, it's crucial to understand that these price declines are temporary for investors who hold TIPS to maturity. The principal values of individual TIPS have risen during this period due to inflation adjustments, ensuring that investors who hold to maturity will receive their initial investment plus the accumulated inflation adjustments¹⁰.

Historical Performance Compared to Stocks:

Compared to U.S. equities, TIPS have historically shown less volatility and comparable returns¹¹. This makes TIPS a potentially attractive option for investors seeking a more stable investment with inflation protection.

Historical Performance Compared to Bonds:

TIPS outperform nominal Treasury bonds when actual inflation exceeds the expected inflation rate priced into TIPS (breakeven inflation)¹². Conversely, TIPS underperform when actual inflation is lower than expected¹². This highlights the importance of inflation expectations in determining the relative performance of TIPS and nominal bonds.

Historical Performance Compared to Gold:

Gold and TIPS yields have shown a significantly high negative correlation¹³. This means that when gold prices increase, TIPS yields tend to fall¹³. However, it's important to note that other factors beyond inflation can influence gold prices, such as economic conditions and currency fluctuations¹³.

Historical Performance Compared to Series I Savings Bonds:

Series I Savings Bonds are another type of inflation-protected security offered by the U.S. Treasury. Like TIPS, Series I bonds adjust their principal with inflation. However, Series I bonds have a different interest rate structure and may be subject to different purchase limitations.

Investors can learn more about comparing TIPS and Series I Savings Bonds at Fidelity.com¹⁴.

Current Yields and Other Relevant Information

As of December 13, 2024, the yield on 10-year TIPS was 2.05%¹⁵. Yields for other maturities are near the high end of their 20-year ranges¹⁰. The 5-year and 30-year TIPS yields were 1.84% and 2.32%, respectively¹⁵. These relatively high real yields can present investors with an opportunity to beat inflation going forward¹⁰.

TIPS are issued in electronic form only and mature in 5, 10, or 30 years¹⁶. The interest rate is fixed at auction and is never less than 0.125%¹⁶. The minimum purchase is $100, and the maximum purchase is $10 million for non-competitive bids and 35% of the offering amount for competitive bids¹⁶.

Auction Frequency:

TIPS are auctioned at different frequencies depending on their maturity:

5-year TIPS: Original issue in April and October, with reopenings in June and
10-year TIPS: Original issue in January and July, with reopenings in March, May, September, and November.
30-year TIPS: Original issue in February, with a reopening in August¹⁶.

Tax Treatment of TIPS

The interest earned on TIPS is subject to federal income tax each year¹⁶. Additionally, any increase in principal due to inflation adjustments is also considered taxable income in the year it occurs, even though the investor does not receive this income until maturity or sale¹⁶. However, TIPS are exempt from state and local taxes¹⁶.

How to Purchase TIPS

Investors can purchase TIPS in several ways:

TreasuryDirect: Investors can buy TIPS directly from the U.S. Treasury through the TreasuryDirect website¹⁷. This involves setting up a secure account and participating in single-price auctions¹⁷.
Banks and Brokers: TIPS can also be purchased through banks, brokers, and other financial institutions³. This may be a more convenient option for investors who already have accounts with these institutions.
Mutual Funds and ETFs: Investors can also gain exposure to TIPS through mutual funds and exchange-traded funds (ETFs) that invest in TIPS¹. This offers the benefits of diversification and professional management.

TIPS Offering Chart:

Conclusion

Treasury Inflation-Protected Securities (TIPS) are a valuable tool for investors seeking to protect their portfolios from the erosive effects of inflation. By adjusting their principal with changes in the CPI, TIPS provides a real return that maintains purchasing power over time. TIPS offers several advantages: inflation protection, safety, regular income, liquidity, tax benefits, and portfolio diversification. However, investors should also consider the potential disadvantages, such as lower yields compared to other bonds, the tax treatment of inflation adjustments, and the potential for price fluctuations in the secondary market.

TIPS are most likely suitable for individuals with a long-term investment horizon concerned about inflation eroding their savings. They can also be a valuable addition to a diversified portfolio, helping to reduce overall volatility and manage risk. Investors seeking higher yields or having a shorter-term investment horizon may find other investment options more suitable, such as nominal Treasury bonds, corporate bonds, or dividend-paying stocks. Ultimately, the decision of whether to invest in TIPS depends on an individual's specific investment goals, risk tolerance, and time horizon.

Works cited

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Ralph V. Estep, Jr.

Christian Financial Consulting

Ralph V. Estep, Jr. is a highly accomplished professional with a diverse background in finance, accounting, technology, and entrepreneurship. As the principal at Saggio Management Group, Inc., he has demonstrated exceptional leadership and expertise in various roles throughout his career.

Ralph's educational journey began at St. Mark's High School in Newark, Delaware before attending the University of Nebraska where he was an esteemed member of the Cornhusker Marching Band and had the privilege of performing at the Florida Citrus Bowl in Orlando.

Continuing his pursuit of knowledge and excellence, Ralph earned a Bachelor of Science Degree in Accounting from the University of Delaware. He further expanded his academic achievements by obtaining a Master's in Business Administration from Wilmington University.

Throughout his professional journey, Ralph has been recognized for his outstanding accomplishments and commitment to excellence. He is a member of prestigious organizations such as the Golden Key National Honor Society and Beta Gamma Sigma International Business Honor Society.

With an extensive range of professional designations including Licensed Public Accountant (LPA), Accredited Business Accountant (ABA), Accredited Tax Advisor (ATA), Accredited Tax Preparer (ATP), and Internal Revenue Service Registered Tax Preparer (RTRP), Ralph possesses comprehensive expertise in tax preparation and financial management.

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