TIPS Bonds: How Treasury Inflation-Protected Securities Work

Treasury Inflation-Protected Securities (TIPS) is a type of Treasury securities that provides protection against inflation and real return.  I don’t know if TIPS is the best bond to buy or not — I don’t think that is the right way to think anyway, e.g., it is better to have a good investment policy and asset allocation plan. But according to Larry Swedroe, academic literature strongly favors TIPS over other kinds of fixed income investment. Whatever the case may be, they are great adds to a well-diversified investment portfolio.

How Treasury Inflation-Protected Securities (TIPS) Work

To provide inflation protection, the principal of a TIPS increases with inflation (and decreases with deflation) as measured by the Consumer Price Index (CPI). Like other Treasuries, TIPS pay interest at a fixed rate twice a year.  The rate is applied to the adjusted principal, as such, the interest payments rise with inflation and fall with deflation.  At the maturity, you receive the adjusted principal or the original principal, whichever is greater — protecting you against both inflation and deflation.

Let’s take a look at an example where you purchased a $1,000 in TIPS at 4.25% interest rate and the CPI rose 3%.  First, the principal is adjusted for inflation, so your principal rises from $1,000 to $1,030, and increase of 3% as per the CPI.  Then the interest payment would be calculated from the new principal.  At the fixed interest rate of 4.25% and adjusted principal of $1,030, the amount of interest would be $43.78.

Key Benefits Of Treasury Inflation-Protected Securities (TIPS)

There are several advantages that make TIPS one of the best bonds to buy, these include:

  • Inflation Protection – Since TIPS adjust for inflation, they protect investors from the risks of unexpected inflation.
  • Real Return — Since interest rates are calculated after the principal is adjusted for inflation, investors are guaranteed a fixed rate of return regardless of inflation.
  • Less Volatility — TIPS are less volatile than traditional Treasury bonds with similar maturity.
  • Good Diversifier — Due to their low correlation to equities and other fixed-income investments, they reduce the overall volatility and risk of your portfolio.
  • No Credit Risk — The chance that the government will default on bonds is virtually none — at least in theory.
  • Tax Exemption — Like other Treasuries, TIPS are exempt from state and local taxes.  However, interest payments and inflation adjustments that increase the principal are subject to federal tax in the year that they occur.
  • Marketable – TIPS can be bought and sold in the secondary securities market.  You do not have to hold TIPS to maturity.
  • No Fee — You can buy TIPS at no fee through TreasuryDirect.  However, there is a $45 fee if you wish to sell TIPS before the maturity date.

Where To Find The Latest Rates On Government Bonds

Here are a few sites where you can find the most recent interest rates for Treasury securities:

Conclusion

Of course there are some disadvantages to consider, but overall I think TIPS is a very good fixed-income investment — especially for retirees who are most sensitive to inflation.  There are a lot of good information on TIPS.  If you are interested in more information, I highly recommend the TreasuryDirect TIPS Research Center.  Larry also has a great section on inflation-protected securities in his new book: The Only Guide to Alternative Investments You’ll Ever Need.

About the Author

By , on Jan 20, 2009
Pinyo
Pinyo is the owner of Moolanomy Personal Finance. He is a licensed Realtor specializing in residential homes in the Northern Virginia area. Over the past 20 years, Pinyo have enjoyed a diverse career as an investor, entrepreneur, business executive, educator, and financial literacy author.

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Leave Your Comment (14 Comments)

  1. Pinyo says:

    @Ralph – If your Association meets the Entity Account requirements, then yes, it can buy TIPS.

    TIPS are sold in increment of $100. I am not sure about the fee because I think that depends on the bank or broker that you use. See: http://www.treasurydirect.gov/.....s_sell.htm

    Personally, I just buy TIPS via ETF and Vanguard mutual fund. There is a little bit of overhead in the form of trade commission/expense ratio, but it’s more convenient for me.

  2. Ralph G. Waclawicz says:

    Can a Condominium Association buy TIPS?

    If I want to invest $1,000 in TIPS, do I have one TIP worth $1,000 or 1000 TIPS? When I sell my TIPS prior to its maturity date is the $45. fee charged for the total sale or is the $45. fee per TIP?

  3. Mike says:

    pinyo, I notice that some tips in the secondary market have a negative ytm on the accrued principal. Can you explain how that works?

  4. Pinyo says:

    @Lisa — If you buy TIPS through your broker (if your broker can do this), there’s usually a fee. There are also other ways to purchase TIPS through broker, such as, through TIPS ETFs or TIPS funds. For ETFs, you’ll be paying trade commission on each buy/sell transaction, plus a small percentage in expense ratio. For funds, there may or may not be a load and/or transaction fee, but even if you manage to avoid both, you’ll have to pay a small percentage in expense ratio regardless. That said, investing in low cost TIPS funds like iShares Barclays TIPS Bond Fund or Vanguard Inflation-Protected Securities is probably the way to go if you want to avoid the auction, and be able to automatically reinvest back into the fund.

  5. Lisa says:

    If my financial institution handles the purchase of TIPS rather than my doing it myself through the auction, should I expect a fee associated with this or some other adjustment to the value of the TIPS?

  6. Andy says:

    Great article. I recently bought a TIPS fund and seems to be a pretty simple way to diversify inflation risk (I do believe by 2015, US will have 5%+ inflation and 10%+ interest rates).

  7. Pinyo says:

    @Rick — It depends on where you purchased your bonds. At maturity, you usually have the option of trading your bonds for cash, or reinvest your money to buy another security. With TIPS you can also sell before it matures. If you go through TreasuryDirect and sell before maturity, there’s a $45 fee.

  8. Rick says:

    How are the TIPS redeemed at maturity?

  9. Pinyo says:

    @Sam — corporate bonds provide better nominal interest rate (i.e., no inflation protection), but you are also taking on greater credit risks and give up some tax advantages. I am not saying it’s better or worse, but there are definitely trade-offs to consider.

    @Mr. GoTo — I-Bond also has similar inflation-protection feature, but it has its own limitations as well — specifically, there’s a $5,000 limit per calendar year and it’s non-marketable. But, yes, it could work out better for some individuals.

    @Craig — Since I am not a professional, I will abstain from recommending anything. Personally, I think TIPS is one of the best after doing my research on various bonds; although, I am tempted by higher interest corporate bonds.

  10. Craig says:

    It seems like a very safe bond to purchase, something you would hold for years. Is this something you recommend? What are the other type of bonds out there and would you recommend others over this?

  11. Mr. GoTo says:

    I-bonds may be a better option for some because all taxes are deferred until the bond is redeemed.

  12. Sam says:

    From what I have been reading, many are recommending corporate bonds since their returns are so much greater than government bonds currently. I think you can get the highest grade bonds w/ interest around 7-10% nowadays. But they are still more risky than the TIPS you recommend. I haven’t put my money in either yet.

  13. Manshu says:

    These bonds are a great product for safety and better than most fixed income offers that banks give nowadays.

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