Investor Facts: What Are TIPS?

Treasury inflation-protected securities (TIPS) are a type of bond issued by the U.S. government that guarantee a return equal to at least the rate of inflation.

Money invested in Treasury inflation-protected securities thus is guaranteed by the government to increase in value at the rate of inflation as shown by the Consumer Price Index (CPI), plus some interest.

The CPI is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. It’s what people mean when they say inflation is higher or lower.

Prices for the goods and services used to calculate CPI are collected in 75 urban areas throughout the country from 23,000 retail and service establishments, according to the Bureau of Labor Statistics, which gathers the information monthly. Data on rents are collected from about 43,000 landlords or tenants.

TIPS pay interest twice a year and the interest payment is adjusted to account for official CPI inflation. TIPS bonds come in maturities of five, 10 or 30 years.

Investors tend to buy TIPS when they believe that a rising inflation rate might put their future purchasing power at risk.

At maturity, the investor receives the initial investment back, adjusted upward for inflation. If the economy instead experiences deflation, or falling prices, the original investment is returned whole, an additional protection against potential loss.

While we haven’t seen much inflation in the last couple of decades, that is beginning to change. The Federal Reserve has been raising the interest rate in a bid to tamp down inflation, always a dicey proposition since predicting the path of economic growth is close to impossible.

TIPS as a hedge

TIPS can act as a kind of hedge position in an investor’s fixed-income portfolio, a bet that inflation will be less predictable and thus important to insure against through a guaranteed inflation-adjusted return of capital.

You want to own TIPS when there is risk of increased inflation since Treasury inflation-protected securities are designed to keep up with CPI. You want to generally avoid owning them during times when inflation is decreasing over the long-term.

That said, investing in TIPS isn’t something investors should generally attempt over the short term since the Federal Reserve can’t predict the short-term path of inflation any better than anyone else.

They are not a substitute for money market investments or other short-term places to hold cash, such as certificates of deposit.

As the Fed targets inflation at around 2%, so you can’t expect to earn much outside this range by investing in TIPS.

Nevertheless, inflation has been historically higher in the past, close to 3% or so, so TIPS could be considered a tool aimed at capturing the difference between current CPI and a reversion to the historical average — if you own them for long enough to realize the gain.

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