TIPS are issued by the U.S. government and, like other Treasury securities you may add to a portfolio, are backed by the full faith and credit of the federal government. However, there’s a major difference: Unlike regular Treasuries, TIPS are adjusted for inflation based on the consumer price index (CPI).
Yes, inflation does affect bonds and can be the “enemy” of bondholders. Consider a traditional bond that pays 3 percent while inflation is only 1 percent. Your purchasing power is positive since your return is greater than inflation. However, if inflation is 4 percent during the life of the bond, despite having a positive return, your bond has not kept up with inflation and your purchasing power is reduced.
TIPS can help lessen how inflation affects bonds by providing a potential for a total rate of return that adjusts with inflation.
The principal amount of TIPS is linked to the CPI, published by the Bureau of Labor Statistics, adjusted for three months prior. The inflation-adjusted principal value will not be realized until the issue matures or is sold.
Here’s an example. Say you own TIPS valued at $10,000 with a coupon of 5 percent. Normally, that would result in income of $500 for the year (TIPS issue interest payments twice a year). If inflation goes up 3 percent, the principal would be adjusted by the same percentage, resulting in you receiving 5 percent of $10,300 for the year, or $515.
If the CPI declines 4 percent, the $10,000 principal on your TIPS is readjusted to $9,600, and the 5 percent coupon gives a return of $480.
TIPS may seem like an obvious choice to help protect against inflation, but they have pros and cons.
Pros: TIPS offer a steady, fixed return with a potential for a rising principal. And they have low credit risk with protection against rising inflation.
Cons: Like traditional bonds, rising interest rates generally reduce the price of TIPS, just as lower interest rates drive prices higher. Also, as rising prices result in a rising principal amount for TIPS, declining prices mean a declining principal value for TIPS, which can lower the return.
Generally, TIPS outperform traditional government bonds when inflation is higher than the market expects. And they underperform traditional U.S. government bonds when inflation is lower than market expectations.
Interest payments from TIPS are subject to federal tax but exempt from state and local taxes. In addition, the amount of increase in principal value is considered taxable income at the federal level, though exempt from state and local taxes. That can create the “phantom income” effect: Increases in principal are taxed when they occur, not when they are actually realized.
Talk with a financial advisor to explore how TIPS can work for your portfolio.