Treasury Inflation-Protected Securities (TIPS)

Home
Income Builder
Net Realizable Value
Contract Research
About Steve
Contact Steve

Back

Treasury Inflation-Protected Securities (TIPS) are bonds that are backed by the full faith and credit of the U.S. government.  Unlike conventional Treasury bonds, they are structured uniquely to provide some protection against rising inflation.  Since they were introduced in the late 1990s, TIPS have become quite popular with investors. 

How TIPS work.  The interest rate on TIPs is set at issuance and fixed until maturity.  However, the principal amount of the bond is adjusted for inflation using the U.S. City Average All Items Consumer Price Index for All Urban Consumers (commonly known as the CPI).  Interest is paid semi-annually on the inflation-adjusted principal.  At maturity, investors receive either the inflation-adjusted principal or par value, whichever is higher.

To illustrate, assume a five-year inflation-protected bond with initial face amount of $1,000 has an interest rate set at auction of 2.0%.  If the inflation rate is zero for the first six months, then the first semi-annual interest payment would be $10.00 ($1,000 X 2.0% ÷ 2).  If the CPI for the second six months rises 2.5% (or at roughly a 5% annual rate), then $25.00 would be added to the principal amount of the bond and the second semi-annual interest payment would be $10.25  ($1,025 X 2.0% ÷ 2).  If inflation stays fixed at 5% for five-years, then the inflation-adjusted principal balance would grow to $1,245 and along the way, the bondholder would collect semi-annual interest payments equal to 1.00% of the inflation-adjusted balance.

In effect, the total annualized return on the bond in this example is 7%, which is equal to the 2% cash coupon plus the 5% principal amount adjustment.  The cash coupon therefore represents the real rate of return (above the rate of inflation).

The TIPS yield quoted in the newspapers does not include the inflation adjustment.  So to compare the yield on TIPS with conventional U.S. Treasury securities, you should subtract the TIPS yield from the yield on the comparable maturity Treasury Note.  On October 10, 2008, the yield on the 1.375% TIPS due July 2018 was 3.02%, while the yield on the Treasury note with the closest comparable maturity, the 4% Treasury Notes due August 2012 was 3.87%.  The difference between the two, namely 0.85%, is viewed as the implicit assumed rate of inflation embedded in the 10-year Treasury Note's yield.  If inflation, as measured by the CPI, is higher than 0.85% on average over the 10-year period, you would earn a higher rate of return by owning the 1.375% TIPS.  If inflation is lower over that 10-year period, you would fare better with the 10-year Treasury Note.

Alternatively, you can compare yields by adding the recent year-over-year increase in the Consumer Price Index to the TIPS yield and subtracting that total from the yield on the comparable maturity Treasury note.  For example, the year-over-year increase in the July 2008 Consumer Price Index (which will be used to calculate the principal adjustment on TIPS for the month of October) was 5.18%.  This plus the TIPS yield of 3.02% equals 8.20%.  If inflation continues at the same rate for the next ten years, then 8.20% would be your total return on the 1 3/8% TIPS due 2018.  This hypothetical 8.20% return is 4.33% or 433 basis points above the 3.87% yield on the 10-year Treasury Note.  Since this difference of 4.33%, known as the TIPS spread, is so high, it is reasonable to expect that either inflation will fall in the months ahead or the yield on the 10-year Treasury Note will rise.  On the other hand, if the TIPS spread is exceptionally low (and especially if it is negative), it is probably a safe bet that inflation will rise in time or that the yield on the 10-year Note will fall.

Risks.  There are essentially four risks with TIPS:

First, real interest yields on TIPS may rise, especially if there is a sharp spike in interest rates.  If so, the rate of return on TIPS could lag behind other types of inflation-protected securities, like floating rate notes and T-bills.  If the rise in real rates is high enough, TIPS could fall in price and produce negative total returns.  However, TIPS should still outperform most other fixed-income securities in an inflationary environment over time.

The real yield on TIPS has fluctuated over the past several years and so have total returns.  In the late 1990s, when TIPS were relatively new, the U.S. government paid a very generous real rate of interest on TIPS, as high as 4%.  From 2001 on, as more investors flocked to TIPS, their market prices rose and real yields declined.  This produced very attractive total rates of return for early investors in TIPS.  According to the Lehman Brothers TIPS Index, the average total return on TIPS was 16.6% in 2002 and 8.4% in 2003.  High total returns on TIPS were helped by Federal Reserve policies that lowered interest rates.

Once the Fed started raising rates, however, TIPS began to underperform.  The Lehman TIPS Index generated a total return of only 2.84% in 2005 and 0.4% in 2006.  When the Fed reversed course in 2007, yields on TIPS began to fall and so they generated a superior total return of 11.6% in 2007, according to the Lehman Index.  In 2008, the average TIPS issue declined 1.8%, according to my estimates.

Second, the CPI might not accurately match the general inflation rate; so the principal balance on TIPS may not keep pace with the actual rate of inflation.  If so, the bond market may assign a higher discount rate (i.e. real interest rate) on TIPs, which would cause them to underperform and perhaps even to decline in price.

Third, the accrued principal on TIPS could decline, if there is deflation (i.e. if the CPI declines).  However the principal balance on TIPS cannot fall below par value, so newly-issued TIPS, with very low inflation-adjustments, are not much at risk.  Rather, seasoned TIPS issues, which carry many years of inflation-indexed accruals, could theoretically suffer a more significant drop in principal, if deflation continues over several years.  Of course, there have been no periods of extended deflation in the U.S. for at least the past 70 years.

Finally, TIPs do not pay the inflation-adjusted balance until maturity.  So you have to assume that the U.S. government will be able to repay you.  (TIPS are a good deal for the Federal government because the cash interest payments on them are lower than conventional Treasury securities.)

Tax Considerations.  Like all U.S. Treasury securities, TIPS are subject to Federal tax, but exempt from state and local taxes.  Investors in TIPS must pay taxes on both the current interest payment and the accrued principal inflation adjustment.

Since tax is payable on both current interest and the inflation-adjusted increase in principal, some investors may prefer to include TIPS in tax deferred accounts, such as IRAs and 401(k)s.

Where to buy TIPS.  Individuals can buy TIPS at issuance directly from the Federal government on the Treasury Direct website (www.treasurydirect.gov), after setting up a personal account.  At the regular semiannual auctions for TIPS, held in October and April, most individual investors submit non-competitive bids, whereby they agree to accept whatever rate or yield is determined at auction.  However, they can choose instead to submit competitive bids.  TIPS, like other Treasury securities, must be purchased in multiples of $1,000, with a minimum purchase of $1,000.  The government does not charge a commission on the purchase or any cost to maintain a Treasury Direct account.  Since individuals are purchasing the bonds directly, the general assumption is that they will hold the bonds until maturity.  However, it is possible to sell TIPS before they mature through Treasury Direct.

Alternatively, individuals can buy newly-issued TIPS, as well as those that trade in the secondary markets from broker-dealers for the customary fees and mark-ups.  This gives them greater liquidity as well as the ability to purchase TIPS of all maturities more easily.

Information on TIPS.  Quoted real yields and market prices are published every week in Barron's and daily in the Wall Street Journal Online (subscription required).  The TIPS tables from these sources also include the accrued principal balance on each TIPS security.  Principal accrual figures for every outstanding TIPS issue can also be accessed from Treasury Direct at  http://www.treasurydirect.gov//instit/annceresult/tipscpi/tipscpi.htm.

TIPS Mutual Funds.  Several mutual fund families offer inflation-protected bond funds.  The three funds with which I am most familiar are the Fidelity Inflation-Protected Bond Fund (FINPX), T. Rowe Price Inflation-Protected Bond Fund (PRIPX) and Vanguard Inflation-Protected Securities Fund (VIPSX).  These funds have a stated policy of investing 80% of their assets in TIPS.  The remaining 20% can be invested in other financial instruments, like variable and fixed-rate (investment grade) bonds, futures, interest rate swaps and options.  This flexibility introduces another element of risk, but it also gives the fund managers more tools to respond dynamically to market conditions.

Individuals who own TIPS directly must pay taxes on the annual change in inflation-adjusted principal.  However, mutual funds typically distribute additional shares equal to the inflation adjustment, which individuals can sell if necessary to pay taxes.

There are two exchange-traded funds that focus on inflation-protected securities.  The iShares Lehman TIPS Bond Fund (Ticker Symbol: TIP) and the SPDR Barclays TIPS Fund (IPE).  The funds are benchmarked to the Lehman Brothers TIPS index and carry expense ratios of about 20 basis points.  As with all ETFs, investors can purchase these TIPS ETFs through a stock broker by paying a commission.  These ETFs may be a good choice for 401(K) accounts that do not offer a TIPS mutual fund, but allow participants to purchase stocks. 

I-Bonds.  As an alternative to TIPS, investors should also consider Series I Savings Bonds, a form of U.S. Savings Bond that offers inflation protection.  I-Bonds work pretty much like TIPS, with a CPI-based adjustment to bond principal and a fixed rate of return over and above the inflation rate.  However, no interest income is received until the bonds are redeemed.  Unlike TIPS and TIPS mutual funds, investors are not required to pay any taxes on I-Bonds until redemption.  The bonds carry a 30-year maturity, but early redemptions are permitted after 12 months.  Investors cashing out I-Bonds during the first five years must pay a penalty of three months interest.

In January 2007, the Treasury department cut the maximum purchase of savings bonds from $30,000 to $5,000 per Social Security number.  The $5,000 limit applies individually to Series EE and Series I bonds and also to purchases made electronically or in paper form.  Thus, the maximum amount of Series I bonds that can be purchased by one individual is $10,000 annually:  $5,000 electronically and $5,000 in paper form.  Total annual purchases of savings bonds, including both Series EE and Series I bonds, by one individual is therefore $20,000.

I-Bonds purchased from now until April 30, 2009 will carry an annualized interest rate of 5.62% for the first six month period.  This represents a 0.7% real rate of return (fixed over the life of the bond) and a CPI-based semi-annual inflation-adjustment of 2.46%.  The inflation adjustment is recalculated every six months.  The next six-month inflation adjustment on May 1, 2009 will likely be much lower than the current rate of 2.46%, due to the sharp drop in commodity prices.  In fact, the adjustment could be close to zero.  Investors wanting to learn more about Series I Savings Bonds can obtain information at the I-Bond website (http://www.treasurydirect.gov/indiv/research/indepth/ibonds/res_ibonds.htm)

T-Bills and other floating rate instruments.  3-month Treasury bills are the simplest and among the most liquid of Treasury securities.  They have historically offered great protection against inflation, except in recent years.  Their interest rate is recalibrated every three months based upon conditions in the money market and current inflation.  Over the long-term, they have paid a real rate of interest equal to zero.

Corporations also issue floating rate securities that typically pay interest at a spread of 5 to 95 basis points over the 3-month U.S. dollar London Interbank Offered Rate (LIBOR).  As its name implies, LIBOR is the rate that banks lend money to each other.  Corporate floating-rate notes pay higher yields and carry greater credit risk than T-Bills, but they often represent better value.

Another alternative to TIPS is a certificate of deposit from a financial institution, such as a bank.  With FDIC deposit insurance recently raised on deposits to $250,000, CDs offer an attractive current return with low risk.  Shorter maturities (i.e. 3-months, 6-months and 1-year) provide inflation-protection, since they can rollover at higher rates, but they also expose investors to lower potential yields, if inflation falls.

Conclusion.   TIPS provide investors with a real rate of return plus inflation protection through CPI-based adjustments to principal.  Market-based returns on TIPS will depend upon interest rate trends and inflation expectations.  Over time, they should provide adequate protection against inflation, but they are also exposed to the risk of deflation, especially for seasoned TIPS issues.  TIPS should also over time be less volatile than most other fixed income securities, especially those with longer maturities.  Even so, investors may want to include other inflation-protection alternatives in addition to TIPS in their portfolios to gain better inflation protection and higher potential returns.

Limited Time Offer:  Get a 6-Month Subscription to Income Builder, a monthly newsletter for individual investors, at the discounted rate of $145.00.  That's a 25% discount off of the regular price.  To learn more about Income Builder, click here.  To access the subscription form, click here.

Additional information on TIPS is available in the Fixed Income Investing section of this website.

Also, see:
Market Returns on TIPS for 2011 at http://www.larkresearch.com/tipsreturns2011.htm.
Market Returns on TIPS for 2012 at http://www.larkresearch.com/tipsreturns2012.htm.
and Market Returns on TIPS for 2013
at http://www.larkresearch.com/tipsreturns2013.htm.

Information sources for this analysis and for further reading:

Annette Thau, “An Investor's Guide to Inflation-Protected Securities” in the AAII Journal, May 2007, p.5, published by the American Association of Individual Investors (www.aaii.com)

Neil A. O'Hara, “An Inflation Hedge May Be Worth A Second Look” in The New York Times, June 17, 2007.

James Grant, “Forget TIPS” in Forbes Magazine, March 29, 2004, p.102.

Updated December 17, 2009.  Links updated July 10, 2013

Stephen P. Percoco
Lark Research, Inc.
P.O. Box 768
Norwood, MA  02062
www.larkresearch.com

(732) 763-0763
incomebuilder@larkresearch.com

© 2008  Lark Research, Inc.  All Rights Reserved.  Information is carefully compiled but not guaranteed to be free from error.  Specific reference to any specific security should never be construed as a solicitation to either buy or sell.  Reproduction without permission from the publisher is prohibited.

 

Back

Please send your comments and suggestions to: webmaster@larkresearch.com.