The Federal Reserve aims for an average annual inflation rate of 2%. But they don’t directly control the value of the dollar or the price of goods and services, and inflation sometimes leaps unexpectedly. Inflation dilutes the value of your retirement savings, and all other savings for that matter.
That’s precisely why you shouldn’t leave all your money sitting in a savings account. Instead, you can protect against inflation by investing money to earn a return higher than the pace of inflation. In the wake of the COVID-19 pandemic and the massive “printing” of new money to spend on stimulus measures, many investors have looked for inflation-proof investments to avoid a post-pandemic drop in the dollar’s value.
One of these strategies includes unique U.S. Treasury bonds called Treasury inflation-protected securities, otherwise known as TIPS.
How Do TIPS Work?
Treasury inflation-protected securities fluctuate in value specifically based on inflation rates. The Treasury ties their value directly to the Consumer Price Index (CPI), which measures inflation.
These bonds pay interest (coupon payments) twice per year based on a fixed rate declared when the Treasury first sells each bond. Investors receive an interest payment based on that interest percentage of the principal amount — the value of the bond. However because the principal amount changes along with inflation, so too do the semiannual payments.
The higher the inflation rate, the greater the jump in the value of the bond. But these adjustments work both ways: your principal and interest payments both fall during deflationary periods. If the CPI falls before your term is up, you are guaranteed to get your principal back, but will not benefit from any growth.
Because TIPS adjust in principal value — unlike normal bonds — they generally pay less in interest than normal Treasury bonds.
The Treasury issues TIPS at five-, 10-, and 30-year maturities. You can buy them new, directly from the Treasury, in increments of $100. Or you can buy them from other investors on the secondary market through a brokerage account like SoFi Invest.
Example TIPS Investment
Confused yet? Don’t fret — TIPS work differently than normal bonds, which makes them hard for many investors to wrap their head around. An example helps clarify how they work.
Say you buy $1,000 in TIPS that pay 1% interest. In the first year, you receive $10 in interest (1% of $1,000), split into two semiannual payments of $5 apiece.
Over the course of that first year, inflation runs at 2%. So the face value — the principal amount — of your TIPS adjusts upward from $1,000 to $1,020 at the end of that year.
In the second year of ownership, you collect 1% of the new principal amount of $1,020. That comes to $10.20, again split into two semiannual payments, this time of $5.10 apiece.
At the end of that second year of ownership, the principal amount adjusts again, based on the inflation rate that year. If inflation jumps by 4% that second year, your principal amount adjusts upward to $1,060.80. For the following year, you collect interest payments equal to 1% of $1,060.80, or $10.61 total.
And so on, until the bond matures.
You can sell your TIPS bonds on the secondary market if you like. Or you could keep them until maturity, and receive the final adjusted principal amount back.
Advantages of TIPS
To begin with, TIPS are as risk-free as investments get. They come with the full backing of the U.S. government, they protect against inflation, pay a predetermined interest rate, and guarantee that you won’t lose your initial investment.
Upon maturity, you receive back more than you paid, in direct proportion to inflation since you purchased — assuming that inflation was positive during your period of ownership.
Your interest payments also rise over the course of your TIPS ownership, as the principal value rises. That adds another layer to your protection against inflation.
In short, TIPS offer straightforward protection against inflation, plus a small return.
Downsides of TIPS
That last point deserves special emphasis: a very small return. Investors don’t get rich form TIPS; they serve as more defensive investments.
As noted above, TIPS usually pay lower interest rates than traditional Treasury bonds. That’s the tradeoff for the upward mobility of the principal amount.
In a period of slow or no inflation, you earn a low return. Periods of zero growth do happen, especially with the Federal Reserve’s dovish stance in recent years keeping interest rates low, which hasn’t seen an accompanying rise in inflation. When Japan instituted similar policies in the late 1990s, a period of zero growth lasted for about a decade.
During periods of deflation, your interest payments actually fall since they are calculated off of the downwardly-adjusted principal.
Speaking of interest payments, you pay regular income taxes on them. The IRS taxes them like dividends, rather than capital gains, because you earn them as income within the same year.
How Do TIPS Differ From Regular Bonds?
Traditional bonds pay a predetermined interest rate for their entire lifespan. You earn interest each year, and when they mature, you get back your original principal amount (purchase price). The principal amount never changes.
The principal amount on TIPS does change, adjusting every year based on the inflation rate that year.
Imagine you purchased a traditional 10-year treasury bond paying 4% on a $1,000 investment. You would earn $40 in income every year, regardless of any changes in the economy, and then you’d receive the principal $1,000 back at the end of the 10-year period.
High inflation would eat into your returns because your $1,000 would be worth less when you got it back than when you invested it. And if the inflation rate surpasses your 4% interest rate, then your real return would in fact be negative.
If you instead invested in 10-year TIPS that started at only 3.5% with that same $1,000, your interest payments would start out lower at around $35. Then, the inflation adjustment would increase or decrease your principal on a monthly basis, which would in turn impact your interest payment.
If the rise in the inflation index increased your principal to $1,250, then your new interest payment would be $43.75. As inflation continues to rise, so do your regular payments.
Moreover, as long as the economy doesn’t experience deflation, you will also benefit from the upwardly-adjusted principal amount you receive back once the bonds mature.
Where Do TIPS Fit Into Your Portfolio?
Treasury inflation-protected securities offer a valuable hedging tool for your personal investment portfolio. They protect you against inflation without the heightened risk of commodities or precious metals.
That makes them low-risk, low-return investments — a safe-haven investment for playing defense, particularly if you worry a rise in inflation is coming. As low-risk investments, they make for a good short-term investment to simply avoid losing money to inflation.
I keep some of my capital in an ETF that holds TIPS to avoid losses from inflation while parking money. As a real estate investor, I typically set aside money for upcoming property purchases, but I don’t always know when I’ll need that money. A deal might come along next month, or I may need to wait a year for the right deal.
As safe as TIPS are, however, the majority of your money should probably work harder for you, earning a higher long-term return. Speak with an investment advisor about the ideal asset allocation for your age and long-term goals.
If you suspect higher inflation lurks in the near future, TIPS can make a great addition to your portfolio.
With virtually no risk of losses and easy liquidity, they offer more security than other inflationary hedges. The federal government guarantees that you won’t lose money on them.
But that doesn’t mean they pay well. You could easily find yourself earning one-tenth the long-term average return of stocks. As you structure your portfolio, consider TIPS as a conservative backstop reserve, rather than the main force of your investment dollars out working to earn you money.