Treasury Inflation-Protected Securities (TIPS)

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 February 19, 2016, the yield on the 2.0% TIPS due January 2026 was 0.53%, while the yield on the Treasury note with the closest comparable maturity, the 1.625% Treasury Notes due February 2026 was 1.75%. The difference between the two yields, namely 1.22% or 122 basis points, is known as the TIPS spread. It is viewed as the implicit assumed rate of inflation embedded in the 1.625% Treasury Note’s yield.

If inflation, as measured by the CPI, is higher than 1.22% on average over the 10-year period, you would earn a higher rate of return by owning the 2.0% TIPS due 2026. If inflation is lower over the nearly 10-year period to 2024, you would fare better owning the 1.625% Treasury Note due 2026. (The year-over-year increase in the CPI for November 2015, which was used to calculate the inflation adjustment for all TIPS on February 1, was 0.71%, which is below the TIPS spread. Iff the market is right on both the TIPS yield and the comparable maturity Treasury yield, inflation will pick-up over the next ten years, but remain at an average rate of 1.22% for the entire ten year period.)

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 time 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%. In recent years, investors have flocked to TIPS, driving their yields down to record low levels. Since the financial crisis, yields on shorter maturity TIPS have been negative. (i.e. their prices have been driven higher than the total sum of principal plus interest to be received over the entire life of the issue.) Why would investors pay so much for TIPS? Presumably because they believe that the inflation adjustment will more than offset the losses on contractual principal and interest, so that the net amounts that they receive on the TIPS will still exceed the amounts that they would receive owning comparable maturity, fixed yield Treasury notes.

In a rising rate environment, the yield on TIPS, which is equivalent to the real rate of interest on TIPs, often rises. Consequently, TIPS often underperform during these periods. In fact, total returns on TIPS can be negative.

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 also 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. Most individual investors submit non-competitive bids for newly issued TIPS at the regular semiannual auctions for TIPS, held in October and April. However, they can also submit competitive bids.

Like other Treasury securities, TIPS 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 with the customary fees and mark-ups. This gives investors 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 accruals 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. Examples include the Fidelity Inflation-Protected Bond Fund (FINPX), the T. Rowe Price Inflation-Protected Bond Fund (PRIPX) and the 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.

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

There are a number of exchange-traded funds that focus on inflation-protected securities. The largest is the iShares Lehman TIPS Bond Fund (Ticker Symbol: TIP). TIPS funds are benchmarked to the Barclays 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 buy stocks.

I-Bonds. As an alternative to TIPS, investors may 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 I-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.

Individuals can purchase up to $10,000 in I-Bonds annually per Social Security number, plus $5,000 purchased with their tax refund money.

I-Bonds purchased from now (February 22, 2016) until April 30, 2016 will carry an annualized interest rate of 1.64% for the first six month period. This represents a 2.0% real rate of return (fixed over the life of the bond) and a CPI-based semi-annual inflation-adjustment of -0.20% (equivalent to a -0.36% annual inflation adjustment). The inflation adjustment is recalculated every six months.

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.

In January 2014, the U.S. Treasury began issuing floating rate notes (FRNs). The FRNs have a two year maturity. Interest payments are based upon discount rates for 13-week (i.e. 3 month) T-bills. They are issued in electronic form and sold in increments of $100, with a minimum purchase of $100.  Detailed information about U.S. Treasury FRNs is available at http://www.treasurydirect.gov/indiv/research/indepth/frns/res_frn.htm.

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. The FDIC currently insures deposits up to $250,000 per individual. Shorter maturities (i.e. 3-months, 6-months and 1-year) provide inflation-protection, since they can rollover at higher rates, but investors must accept the dismally low yields that they currently offer.

Conclusion. TIPS provide investors with a real rate of return plus inflation protection through CPI-based adjustments to principal. Market-based returns on TIPS depend upon interest rate trends and inflation expectations. TIPS should provide adequate protection against inflation, but they are also exposed to the risk of deflation, especially for seasoned TIPS issues. Over time, TIPS should be less volatile than other fixed income securities, especially those with longer maturities, but they can still suffer losses in a rising interest rate environment. Besides TIPS, investors should consider other investment alternatives to gain protection against inflation and higher potential returns.

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

Also see:

Market Returns on TIPS for 2012.

Market Returns on TIPS for 2013.

Market Returns on TIPS for 2014.

Market Returns on TIPS for 2015.

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, published by the American Association of Individual Investors (www.aaii.com)

Daniel W. Wallick and Jill Marshall, “TIPS and the Nature of Inflation Protection” in AAII Journal, December 2010, published by the American Association of Individual Investors.

Jack Duffy, “An Inflation Hedge Carries Its Own Risks” in The New York Times, July 9, 2011.

Updated  May 6, 2014,  August 12, 2015, February 22, 2016

Stephen P. Percoco
Lark Research, Inc.
P.O. Box 1453
Linden, NJ 07036
www.larkresearch.com
(908) 448-2246
incomebuilder@larkresearch.com

© 2008-2016 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.