Treasury Inflation-Protected Securities (TIPS) are issued by the US government. The principal value of TIPS is linked to the Consumer Price Index (CPI). TIPS can be a good hedge against inflation, but there are drawbacks to consider. Loading Something is loading.
Treasury Inflation-Protected Securities (TIPS) are a type of US Treasury bond with face values that are indexed for inflation. When inflation rises or falls, the value of the principal adjusts with it.
The US government issues TIPS, but these investments are not risk free. It is important to understand how TIPS work, as well as the benefits and risks before investing.
How do TIPS work?
Inflation causes a gradual increase in the cost of goods and services, so your money won’t go that far. When inflation rises, you will be able to buy fewer goods and services in the future than you do today.
And inflation can have a negative impact on your investments, especially if you have regular Treasury bonds. The interest rate paid is fixed over the life of the bond, so interest payments may not keep pace with inflation.
If the rate of inflation exceeds the interest rate on your bonds, you are losing money on your investment. This is why some investors choose TIPS to diversify their portfolios.
“TIPS are like other government-issued bonds in that they pay you a percentage return based on the principal of the bond,” explains Katherine Fox, CFP® Professional and Investment and Philanthropist Advisor at Arnerich Massena, Inc.
However, the main difference between TIPS and other government bonds is that when you invest in TIPS, your principal increases with inflation and decreases with deflation. “As inflation increases, the face value of TIPS also increases. Although you are still being paid a fixed return, that return will increase as the face value rises with inflation,” says Fox.
TIPS are linked to the consumer price index (CPI), which affects your interest and the price you are paid when TIPS expire. That means they can help combat inflation risk more than other investment vehicles.
Note: The CPI measures the average change in the price that consumers pay for products and services.
And since the rate is tied to the principal, your interest payments may vary. To estimate the value of a security you already own, you can check the issue date with TreasuryDirect.
Advantages and disadvantages of TIPS
The main benefit of TIPS is that they are protected during periods of high inflation, as the face value of TIPS holdings will rise at the same rate as the CPI. And TIPS are among the few investments that can outpace inflation while still being backed by the US government.
However, the fact that your equity rises with the CPI can also be a downside, according to Jason Blumstein, CFA and founder of Julius Wealth Advisors. That’s because the principal increase is federally taxable, even if you don’t receive it until you sell or mature the bond, he explains.
And Fox points out that TIPS are not an investment guaranteed to rise during periods of high inflation. Investors’ forward-looking views on inflation also play a role in how TIPS perform in the secondary market, where they are bought and sold after the government initially issues them.
For example, Fox explains, as inflation rose to 40-year highs in mid-2022, the secondary market value of TIPS fell because investors expected inflation to decline significantly in the coming years.
And since TIPS are indexed for inflation, this can be a drawback during deflationary periods. The TIPS rating will decrease as the CPI decreases. And because payments are tied to inflation, it’s hard to anticipate your income, which can lead to unpredictable cash flow.
Tax treatment of TIPS
Fox says that TIPS provides investors with certain tax benefits, as principal increases and interest payments are exempt from state and local taxes.
According to Blumstein, new investors should consider the tax ramifications of TIPS, where capital gains are taxed even if no actual income is produced. He says that investors should also look at the TIPS break-even point for the respective expiration.
“If inflation is higher than the TIPS breakeven point, the investor will be better off with TIPS than with Treasuries,” he explains.
But if it is lower, investors may be better off holding regular Treasuries.
How to buy TIPS
You can buy TIPS by opening an account with TreasuryDirect or a banker or broker. TIPS are sold at auction and you can bid on them in two ways: through competitive or non-competitive bidding.
A noncompetitive bid means that you accept the performance determined in the auction. That means you’re guaranteed to receive the tips you want in the full amount you bid for.
If you make a competitive offer, you will specify the performance you want to receive. Your offer will be accepted for the full amount you want or for less than you want. Your bid may also be rejected if the yield you want is higher than the yield stated in the auction.
According to TreasuryDirect, TIPS are issued in terms of five, 10 and 30 years and are sold in increments of $100. Once you buy TIPS, you can hold them until they expire or sell them on the secondary market.
You can also hold TIPS through a mutual fund or exchange-traded fund (ETF). This can give you more diversification, but since there is no expiration date, there is no guarantee of what the prices will be in the future.
Jamie Johnson is a Kansas City-based personal finance writer whose work has appeared on several of the nation’s top finance and business sites, including Insider, Credit Karma, Bankrate, Rocket Mortgage, Fox Business, Quicken Loans, and The Balance. Over the last five years, he has devoted more than 10,000 hours of research and written more than 2,000 articles on personal finance topics.
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Source: www.businessinsider.com