Financial Planning Blog

In Part 1 Treasury Inflation Protected Securities (TIPS) were introduced with a short explanation of how they work. Before discussing how a person may want to invest in TIPS (Part 3), we'll look a number of things to consider before deciding if an allocation to TIPS is right for you

• TIPS are a U.S. Treasury debt instrument and are backed by the full faith and credit of the U.S. government-so they are considered essentially default risk-free. (And, we hope it continues that way.)
• Although TIPS have essentially no credit (i.e. default) risk, they certainly not risk free. As with all fixed income investments you are subjected to interest rate (or market) risk. If you hold TIPS to maturity, you are assured to receive their real interest rate, adjusted for inflation. However, if not held to maturity, TIPS can see significant price fluctuation. When real (i.e. without an inflation component) interest rates go up, the value of TIPS goes down. When real interest rates fall, you would expect TIPS prices to rise. And, if real interest rates stay relatively stable, TIPS prices should remain close to their inflation-adjusted face value. Real interest rates should be more stable than nominal (regular, with an inflation component) interest rates, thus you would expect TIPS to be less volatile than conventional Treasuries.
• All in all, TIPS are arguably one of the safest investments available. However safe TIPS are viewed, the investor should be aware of potential volatility. For example, at the end 2008 TIPS took a significant dive in value, even as nominal Treasuries were rising in price due to the "flight to safety". This was pretty surprising--why would the real yield on TIPS rise, while the nominal yield on traditional Treasuries were falling? A recent study (Cambell, Schiller, Viceria) suggests that Lehman Brothers became a forced seller of TIPS, depressing there prices (a basic short term supply and demand phenomena).
• Evidence (both in the U.S. and in foreign markets) points to negative correlation with of TIPS to stock market returns. This is what makes TIPS an excellent diversifier for a portfolio. Of course, there is no guarantee of this diversification benefit, and it should be noted that in 2008, both stocks and TIPS experienced losses. (See the table below to compare recent returns for TIPS, nominal Treasuries, and The S&P 500.)

• Since you are not assuming inflation risk, you should expect lower returns with TIPS than with conventional Treasury debt of similar characteristics. TIPS are not a way to get rich--their value is in their inflation protection and as a low risk diversifier in your portfolio.
• Even in a deflationary environment, which is a concern these days, there is protection with TIPS. Investors are guaranteed the lesser of the inflation-adjusted principal or par value--i.e. the value of the bond will not be adjusted below par, even with significant drops in the CPI. (However, if you buy at a premium, you can lose some principal.)
• TIPS' taxation makes them a bit complicated. First of all, the fact that the inflation adjustment is taxed makes them makes them a less-than-perfect inflation hedge. You are taxed on both the coupon payment (as interest income) and on the inflation adjustment to the principal (as original issue discount), and you will receive generally receive Form 1099s for each type of income. This also creates the potential for "phantom tax" problems--if the inflation adjustment is large enough, it is possible that the bond will not generate enough income to pay the taxes in a particular year. Most advisors suggest holding TIPS in tax advantage accounts to avoid these complexities. (Using TIPS mutual funds or ETFs also makes this easier.) On the positive side, like all U.S. Treasury debt, the interest payments are exempt from state and local taxes.
• TIPS have a cousin in I-Bonds. I-Bonds are savings bonds that are similar to TIPS in that they provide a fixed rate of interest plus and inflation adjustment. However, there is no coupon payment with I-Bonds--they work like a zero coupon bond. Income is deferred for tax purposes until funds are withdrawn, making them better for taxable accounts. There are also potential benefits to I-Bonds when saving for college.

Still interested in TIPS for a portion of your fixed income investments? In Part 3 we'll look at some of your options in investing in TIPS.