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Tips for Treasury Inflation-Protected Securities Investors

Investment and Asset Management

Protecting yor savings from rising inflation

Inflation can reduce the buying power of your savings. Although there’s nothing you can do to change inflation rates, you might want to consider investing in Treasury Inflation-Protected Securities (TIPS). Like other Treasury bonds, TIPS are a relatively low-risk investment, backed by the full faith and credit of the U.S. government. But unlike other bonds, they also are designed to provide some protection against inflation.

How they differ from other bonds

Like other Treasury bonds, TIPS are U.S. government debt securities that pay a fixed rate of interest every six months until they mature. Currently, TIPS are issued in five-, 10- and 30-year terms. If you hold a bond to maturity, the principal (or “par value”) will be returned to you. What’s unique about TIPS is that the par value is adjusted annually to reflect inflation (or deflation), as measured by the consumer price index (CPI). Suppose you buy $10,000 worth of 10-year TIPS and hold them to maturity. If the CPI rises by 3% per year, then the TIPS’ par value also increases 3% per year, 
reaching $13,439 by year 10. In addition, while the interest rate is fixed, interest payments increase (or decrease) as the par value changes. Assuming the TIPS in our example pay 1% interest, the annual interest payments would start at $100, increase to $103 after one year, $106 after two years, and so on. Ultimately interest payments in this example would reach $134.39. After TIPS have matured, you’ll receive their adjusted par value. But in the event of deflation, you’ll never receive less than the original par value.

Risks to recognize

Inflation protection can be a significant benefit. But TIPS also present several risks you should be aware of, including:

Underperformance when inflation is low or negative. TIPS tend to underperform other types of Treasury bonds in times of low inflation or deflation. A good way to evaluate TIPS is to look at the breakeven rate. Typically, traditional Treasury bonds pay higher interest than TIPS. So for TIPS to outperform those bonds, the inflation rate would have to exceed the gap between those interest rates. For example, if interest rates for traditional bonds are 2.5% higher than those of TIPS, then inflation would need to  exceed 2.5% for TIPS to be the better choice.

Liquidity risk. TIPS generally are less liquid than other Treasury bonds because their secondary market (where investors and brokers buy and sell securities) is less active. Plus, in periods of low or negative inflation, selling TIPS before maturity can result in a loss.

Taxes on phantom income. Earnings on TIPS are subject to federal income taxes (although they’re typically exempt from state and local taxes). These earnings include not only interest payments, but also any increases in par value to keep pace with inflation. This can result in phantom income taxes — or taxes on income that you haven’t yet received. One way to avoid this is to hold TIPS in an IRA or other tax-advantaged account.

Higher personal inflation rates. The CPI is based on average prices for a “basket” of goods and services intended to reflect aggregate U.S. consumer spending. Depending on your spending patterns, your personal inflation rate may be higher than the national average. In that case, TIPS wouldn’t keep pace with how fast prices are rising for you.

Hedging your bets

TIPS typically earn modest returns. But in times of rising prices, they can be useful for hedging against inflation threats. Just be sure you’re aware of the risks before you invest, and talk to your Lenox advisor about other potential investments that offer inflation protection.

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