What Are TIPS?

With the Federal Reserve appearing to be on the cusp of a rate hike, and the prospect of inflation becoming more immediate, it may be time, for some investors, to consider a hedge against inflationary pressure on their portfolios. One such instrument is the Treasury Inflationary Protected Security – or TIPS.

These marketable securities protect investors from inflationary damage by indexing the principal to the Consumer Price Index, a leading measure of inflation. TIPS, which have the added security of being issued by the U.S. government, accordingly raise or lower their par value in line with inflation or deflation rates. TIPS are issued with 5, 10 or 30 year maturity terms.

Interest rates on TIPS are fixed, pay out semi-annually, and are usually low compared to other securities instruments. But as inflation rates rise, so does the principal on which investors earn that interest. In deflationary conditions, the principle (and interest payments) will drop. However, at maturity, investors receive either the original principal or it’s higher inflation-adjusted principal. This protects investors’ principal, even through extended deflation.

There is a tax-related risk with TIPS. Those bi-annual upward adjustments to the principal are considered taxable income by the IRS – even though the principal isn’t actually received until the bond reaches maturity. TIPS are exempt from state and local taxes, which is attractive, but investors should be aware that any “phantom income” caused by principal adjustments can raise your Federal tax bill.

Many investors reduce the tax risk by acquiring TIPS securities via TIPS mutual funds or exchange-traded funds (ETF’s). Others hold them in tax-deferred retirement accounts. TIPS can be purchased directly from the government by individual investors, some of whom choose to avoid mutual fund management fees by buying them themselves – and accept the tax implications.

Here’s an example of how TIPS works:

You invest $1,000 in TIPS, with a 1% coupon rate. With 5% inflation, your principal is adjusted up to $1,050. The interest rate is still 1%, but will be multiplied by the new principal amount, resulting in an interest payment of $10.50. Should deflation of 2% take hold, the interest payment would be 1% of $980, or $9.80 for the year.

There is a secondary market for TIPS, which offers the possibility of liquidating the funds if needed, although not necessarily at their face value.

While income-oriented investors may have little interest in such a low-risk, low-return investment vehicle, those who require protection from inflation may find TIPS to be an ideal component of a comprehensive financial planning strategy.