Investing in bonds that pay a fixed return seems like a smart and stable way to earn steady income. But over time, inflation—which increases the cost of goods and services—can eat away at the real value of your return. Your “nominal” yield may remain constant, but inflation will decrease its purchasing power.
One way to blunt the impact of inflation is to invest in Treasury inflation-protected securities, or TIPS. These Treasury securities link the value of your investment to the U.S. Consumer Price Index (CPI), which tracks inflation. In this way, TIPS provide a built-in hedge against rising costs.
It seems like a no-brainer, since inflation does rise pretty much every year. But it’s not that simple. TIPS come with trade-offs that depend on how inflation evolves and how long you plan to hold them.
What are TIPS?
Treasury inflation-protected securities (TIPS) are bonds issued by the U.S. Treasury Department that are designed to protect against inflation. Unlike standard debt securities, whose yields are based on nominal interest rates, TIPS offer “real” yields that are indexed to inflation (although the CPI data typically lags by about three months).
How TIPS work
The basic mechanism for TIPS is simple:
- The annual interest rate is fixed.
- Your invested principal is updated daily with the CPI.
- Semiannual interest payments rise or fall because they’re applied to the adjusted principal.
For example, suppose you invest $1,000 in a TIPS with a 2% coupon rate. That means you’d normally receive $20 a year in interest, paid in two installments.
If inflation rises by 3%, your principal would adjust to about $1,030 (with a slight lag based on CPI data). The 2% coupon doesn’t change—but it’s now applied to the higher amount. Instead of earning $20 a year, you’d earn about $20.60.
Compare that with a 10-year Treasury note with a 4% coupon. You’d receive $40 a year on your $1,000 investment, and that payment doesn’t change. But if inflation rises by 3%, the purchasing power of that fixed $40 payment declines. After accounting for inflation, the bond’s real return is closer to 1%.
In this case, the TIPS increase both your principal and your interest payments with inflation, while the standard Treasury pays a fixed amount that buys less over time.
TIPS and inflation risk
The main benefit of TIPS is the preservation of the purchasing power of your principal and interest payments, both of which are inflation-adjusted. Still, mitigating inflation risk doesn’t eliminate market risk. TIPS prices still fluctuate based on changes in interest rates and inflation expectations, so you can experience gains or losses if you sell before maturity. For example, if real yields rise or inflation expectations fall, TIPS prices typically decline.
But if you hold TIPS to maturity, you receive the adjusted principal or the original principal—whichever is greater—in addition to those semiannual interest payments.
Break-even inflation: The “tipping” point for TIPS
TIPS typically offer lower yields than standard Treasury securities. The difference between a nominal Treasury yield and a TIPS yield reflects the market’s expectation for future inflation.
For example, a standard Treasury bond offers a 4% nominal yield, while a comparable TIPS yields 1.5% in real terms. The difference between the two—2.5%—is known as the break-even inflation rate.
At this inflation level, you would earn about the same total return from either bond. If you do the math:
- A nominal yield of 4% minus 2.5% gives a real return of 1.5%.
- A TIPS yield of 1.5%, with its principal rising alongside 2.5% inflation, produces about a 4% nominal return.
So, if inflation exceeds 2.5%, TIPS will outperform. If inflation falls below that level, the standard Treasury bond will likely deliver the higher return.
Although the break-even rate is seen as the market’s implied inflation expectation, it can also reflect other factors, such as risk premiums or liquidity differences.
How TIPS are taxed: The “phantom income” catch
Remember how your principal is adjusted upward when inflation rises? That increase is taxable in the year it occurs, even if you won’t receive the cash until maturity. The Internal Revenue Service treats it as “phantom income,” which means you’ll owe federal taxes on it along with your semiannual interest payments. The good news? TIPS, like other Treasurys, are generally exempt from state and local income taxes.
For this reason, some investors prefer to hold TIPS in tax-advantaged accounts, like IRAs or 401(k) plans, where those taxes can be deferred (traditional plans) or avoided outright (Roth plans).
When investing in TIPS makes sense
By now, you probably get a sense of the trade-offs.
TIPS offer inflation protection. They’re backed by the U.S. government, with transparent pricing and marketability. Those are the advantages. But TIPS aren’t especially tax efficient, and their prices can be volatile. If inflation falls short of expectations, there’s also an opportunity cost—you may earn less than you would with a standard bond.
Nevertheless, if you expect higher inflation and can commit your money for 5, 10, or 30 years—the standard TIPS maturities—these securities can provide you with a relatively simple way to diversify while receiving a real return. If not, more flexible options—such as shorter-term bonds or I bonds—may be a better fit.
The bottom line
TIPS offer a straightforward way to protect your capital and purchasing power from inflation’s erosive effects, but they aren’t a perfect hedge, nor are they risk-free. You’ll have to accept market volatility, a potentially long holding period, income taxes on increases in principal value, and the risk of underperforming if inflation comes in lower than expected.
TIPS tend to make the most sense when inflation risk—not just income—is the thing you’re trying to manage. If inflation surprises to the upside, TIPS do their job. If it doesn’t, you’ve paid for insurance you didn’t need.
