Treasury Inflation Protected SecurityEdit
Treasury Inflation-Protected Securities (TIPS) are a class of U.S. government bonds designed to guard investors against inflation by indexing the principal to changes in the consumer price index for urban consumers (CPI-U). Issued by the United States Treasury and backed by the full faith and credit of the United States, TIPS aim to preserve purchasing power while delivering a predictable stream of income.
Investors use TIPS to hedge inflation risk within a diversified portfolio. They can be purchased directly at auction through TreasuryDirect or on the secondary market, and they are also available via mutual funds and exchange-traded funds that focus on inflation-protected securities. The market prices of TIPS move with expectations for future inflation and the overall level of real interest rates, yielding what market participants describe as the Real yield after stripping out inflation expectations. The difference between the yield on nominal Treasuries and the yield on TIPS of the same maturity—known as the Breakeven inflation rate—serves as a gauge of expected inflation embedded in the price of these securities.
How TIPS work
Principal adjustment: The principal on TIPS is adjusted periodically upward or downward in line with changes in the CPI-U. When inflation increases, the principal grows; when inflation declines, the principal can shrink accordingly. The adjustments are designed to maintain purchasing power over time.
Coupon and interest: Each TIPS issue has a fixed coupon rate applied to the inflation-adjusted principal. Because the principal changes, the semiannual interest payments also change. If inflation pushes the principal up, interest payments rise; if inflation falls, interest payments fall.
Maturity and payoff: At maturity, investors receive the greater of the inflation-adjusted principal or the original par value (typically $1,000). This provides a floor against deflation eroding the nominal amount received at the end of the term.
Maturities and issuances: TIPS are issued with maturities of 5, 10, and 30 years, among others, with the Treasury periodically auctioning new issues and providing a market in the secondary market.
Market dynamics and portfolio use
Inflation indexing and hedging: Because the principal and thus the interest payments track CPI-U changes, TIPS provide a direct hedge against inflation in real terms. They function as part of a broader strategy to maintain purchasing power over time, alongside other inflation-sensitive assets and traditional fixed-income holdings.
Deflation protection: If deflation lowers CPI, the principal can fall, but the instrument guarantees repayment of at least the original par value at maturity.
Tax considerations: In the United States, the federal government taxes the interest payments from TIPS, including the portion attributed to inflation adjustments, in the year those adjustments occur. State and local taxes on these instruments are generally limited, though tax rules can be nuanced and may vary over time. Investors should consult a tax professional to understand their specific situation.
Liquidity and access: TIPS trade in the secondary market, and a variety of vehicles—such as mutual funds and exchange-traded funds—offer convenient access for diversified or smaller-scale holdings. Market prices respond to shifts in expected inflation and real interest rates, sometimes producing price movements that diverge from plain-vanilla nominal Treasuries.
Comparisons with nominal Treasuries and other inflation hedges: TIPS differ from nominal U.S. Treasury security in that their value adjusts with inflation, which can affect risk and return profiles. Investors sometimes compare TIPS to other inflation-linked instruments in different markets or to assets like commodities, depending on their goals and tax circumstances.
Controversies and debates
Effectiveness as an inflation hedge: Critics note that the inflation index used for adjustments (CPI-U) is not a perfect measure of all households’ experiences with rising prices. Substitution effects, quality adjustments, and other methodological issues can influence the accuracy of the inflation signal. Proponents argue that indexing to CPI-U provides a transparent, rule-based mechanism to preserve purchasing power, but skeptics question whether the index fully captures personal inflation experiences in all spending baskets.
Tax design and timing: The federal tax on inflation adjustments creates what some investors call phantom income—taxes owed on inflation-related increases in principal even when no cash is realized until maturity or sale. This aspect can reduce the after-tax yield of TIPS for certain investors, particularly those in higher tax brackets or with specific timing considerations. Advocates for alternative designs contend that this tax treatment distorts the true economic return, while defenders emphasize the predictability and transparency of the federal tax system.
Fiscal and macroeconomic considerations: Some observers worry that widespread use of inflation-indexed securities could influence behavior by shifting the cost of inflation risk onto the government or by altering demand signals for inflation. Others view TIPS as a prudent tool for savers and retirees seeking long-run purchasing-power protection, especially in eras of uncertain inflation trajectories.
Accessibility and literacy: While TIPS are a well-established instrument, some market participants argue that retail investors may misprice them or misunderstand the accrual of inflation adjustments and the related tax consequences. Education and accessible vehicles (funds and ETFs) help address these concerns, but awareness remains uneven across investor groups.