What Are Treasury Inflation-Protected Securities (TIPS)?

Worried that inflation might eat away at your investment returns? Since you wouldn't be alone if you did, the U.S. Treasury created Treasury Inflation-Protected Securities (TIPS) in 1997—special government bonds designed to help protect investors when prices rise across the economy.

When inflation rises, both the principal amount you invested and the interest payments you receive increase to help maintain your purchasing power. This sets TIPS apart from regular Treasury bonds, whose payments stay the same—no matter what happens with inflation.

While TIPS typically offer lower initial interest rates than conventional Treasury bonds, they provide peace of mind for investors concerned about inflation's impact on their long-term savings.

Understanding Treasury Inflation-Protected Securities (TIPS)

The principal value of TIPS rises as inflation rises. Inflation is the pace at which prices increase throughout the U.S. economy, as measured by the CPI. Inflation becomes an issue when there isn’t a commensurate rise in real wage growth to offset the negative effects of rising prices.

TIPS are a popular asset for protecting portfolios from inflation because they pay interest every six months based on a fixed rate determined at the bond’s auction. However, the interest payment varies since the rate is applied to the adjusted principal or value of the bond. If the principal amount is adjusted higher over time because of rising prices, then the interest rate will be multiplied by the increased principal amount. As a result, investors receive higher interest or coupon payments as inflation rises. Conversely, investors will receive lower interest payments when there's deflation.

TIPS come in five-, 10-, and 30-year versions, all backed by the full faith and credit of the U.S. government. You can buy them directly through Treasury Direct for as little as $100, or invest through TIPS mutual funds and exchange-traded funds (ETFs), which offer easier trading but charge management fees. 

TIPS and Inflation

Understanding how TIPS prices move with inflation is akin to watching a balloon inflate and deflate. When prices in the economy rise (inflation), the par value or principal of your TIPS investment expands. When (more rarely) prices across the board fall (deflation), your investment contracts, though it can't ever be smaller than the original size.

Say you invest $1,000 in a TIPS bond paying 1% interest annually. If there is no inflation as measured by the CPI, then you'll get $10 in coupon payments for that year. However, if inflation rises 2% during the year, your principal grows to $1,020. Your interest payment is then based on this new, higher amount. Instead of earning $10 (1% of $1,000), you'll earn $10.20 (1% of $1,020). This helps protect your purchasing power as prices rise.

But what happens in the historically rare circumstance that prices across the board fall—say 5%? In this case, your principal would adjust down to $950. Your interest payment would temporarily shrink to $9.50 for that year. However—and this is crucial—you're guaranteed to get back at least your original $1,000 at maturity, even after a period of falling prices.

One caution: While TIPS protect against inflation over the long term, they can still lose value if you need to sell them before maturity. Just like regular bonds, TIPS prices fall when interest rates rise, which is exactly what happened in 2022 when the U.S. U.S. Federal Reserve aggressively hiked rates to fight inflation. 

How To Buy TIPS

As with other Treasury securities, investors can buy TIPS directly from the U.S. government at the Treasury website TreasuryDirect. This entails a login process with several security layers.

You can also buy TIPS directly from your bank or broker. This may be more convenient for those investors who already have a substantial portfolio of securities with a financial institution.

Advantages and Disadvantages of TIPS

Pros of TIPS

The benefits include the following:

• Inflation protection: By this point, it should be obvious that TIPS are specifically structured to safeguard investors against inflation. The principal amount of TIPS is adjusted based on changes in the CPI. 
• Safety and stability: One of the most compelling advantages of TIPS is their safety and stability. TIPS are issued and backed by the U.S. government, meaning they (usually) can be considered lower risk of default.
• Regular interest payments: For investors wanting some cash flow, TIPS provide semiannual interest payments. This feature can be quite important, especially to retirees or those needing a steady and potentially increasing income. 
• Capital appreciation potential: Meanwhile, TIPS can also rise in value. As inflation rises, the principal value of TIPS is adjusted upward. If you sell your TIPS before maturity, they may realize capital gains, especially when inflation is running high. 
• Tax advantages: TIPS offer tax benefits, particularly for investors in high-tax states. While the interest income from TIPS is subject to federal income tax, it's exempt from state and local taxes. 
• Diversification: Though the correlation among investments is always shifting, TIPS can perform differently from other asset classes that may act negatively toward rising prices and inflation. 
• Market liquidity: Last, TIPS are highly liquid securities, that is, they can be bought and sold with relative ease in the secondary market.

Disadvantages of TIPS

Along with those advantages, there are some disadvantages to consider. 

• Lower yield than other bonds: TIPS typically offer lower yields than other bonds. This is because they tend to carry less risk (because the government issues them).
• Inflation adjustment taxation: One significant disadvantage of TIPS is the taxation of inflation adjustments. While the principal value of TIPS increases with inflation, this increase is considered taxable income in the year it occurs, even though you won't receive this amount until the security matures or is sold. This means taxpayers would have to pay tax on something they haven’t received the cash for (yet). 
• Deflation risk: Although TIPS protect against inflation, they are less beneficial during deflationary periods. If the CPI decreases, the principal value of TIPS is adjusted downward. This reduces the overall return on the investment as the overall value of the security decreases.
• Liquidity issues in times of crisis: We mentioned that liquidity was an advantage. However, during financial crises or periods of market stress, when lots of people are trying to cash-out at the same time, it may be difficult to sell (or at least sell for the price you want to).  
• Opportunity costs: TIPS are generally used to hedge against risk rather than act as a booming investment prospect.
  

Best Type of Investor for TIPS

Not everyone needs the inflation protection that TIPS offer. However, certain types of investors may find these government-backed securities particularly valuable for their portfolios.

Retirees and near-retirees often benefit most from TIPS. Living on a fixed income makes them especially vulnerable to inflation's effects on their purchasing power. TIPS's automatic inflation adjustments can help ensure their retirement savings maintain value over time. For example, if inflation pushes grocery prices up 5%, TIPS payments would increase to help offset those higher costs.

Conservative investors who prioritize protecting their principal over maximizing returns are another natural fit for TIPS. Since the U.S. government backs them, TIPS carry minimal default risk. This safety makes them popular with institutional investors like pension funds and insurance companies, who need reliable ways to match their future payment obligations with inflation-protected assets.

Long-term investors worried about inflation's impact over many years may also want to consider TIPS. However, these securities work best as part of a broader investment strategy rather than a short-term inflation hedge.

Tax-sensitive investors in high-tax states get an additional benefit. While TIPS interest is subject to federal taxes, it's free from state and local taxes. However, investors should note that they'll owe federal taxes on the inflation adjustments to principal each year, even though they won't receive that money until the TIPS mature.

TIPS and Nominal Bonds

Let's quickly cover the difference between nominal bonds and TIPS. Nominal bonds and TIPS are both types of bonds issued by the U.S. Treasury, but they differ primarily in how they handle inflation protection. Nominal bonds, also known as conventional bonds, pay a fixed interest rate over the life of the bond, and the principal value remains constant until maturity.

Here's what makes them different:

• Regular Treasury bonds pay the same interest amount every six months, based on their original principal. If you buy a $1,000 bond paying 3%, you'll get $15 every six months, period.
• TIPS adjust both their principal and interest payments based on inflation. That same $1,000 investment might grow to $1,020 if inflation is 2%, meaning your interest payments would grow too.

Have Have TIPS Performed?

In the early 2020s, inflation in the U.S. hit highs not seen in four decades, leading many investors to flock to TIPS for protection. However, that insurance policy didn’t really go according to plan. These inflation-protecting securities fell an average of 14.2% in 2022, performing not much better than regular Treasurys and major equity markets.

To get a sense of how TIPS have done recently, we can look at the stats for the iShares TIPS Bond ETF (TIP):

How TIPS Perform Relative to the Stock Market

We should explain the metric "beta" in the above table for the TIP ETF. The relatively low beta—much less than 1.0—means it's far less volatile than the overall stock market. For instance, when the beta is 0.26, that means if the stock market jumps in one direction, 10%, TIP would only move about 2.6%.

This low beta makes sense since TIPS are government bonds designed for stability and inflation protection rather than aggressive growth.

The Bottom Line

TIPS are among the many types of debt securities offered by the U.S. Treasury Department. You can think of them as Treasurys with a twist—their principal value is tied to inflation to protect investors when the cost of living rises.

It’s important to know that inflation protection comes at a cost, as most of these securities carry lower interest rates than other similar government bonds. Also, bear in mind that at the time of maturity, bondholders are paid the inflation-adjusted principal or original principal, whichever is greater.