Treasury Inflation Protected Securities (TIPS) — What You Need to Know

By Dr. Jim Dahle, WCI Founder

I had a reader recently ask me a question about Treasury Inflation Protected Securities (TIPS), and when I went to send him a link to an article about them, I realized I had never written one dedicated solely to TIPS. And that's despite having 10% of my portfolio (half of our bonds) invested in them for many years.

Here's the question:

“Can you talk more about TIPS ETFs and whether these are something I should consider (presumably in a tax-protected account?). I've read on TIPsWatch that these funds have actually failed to keep up with inflation. However, I just don't understand TIPs well enough, and I know not to invest in things I don't understand. Therefore, I don't see myself building a TIPS ladder. Truthfully, the more I read, the more confused I get. And given the variety of opinions I read, I'm starting to conclude that if I buy things like a TIPs ETF or individual TIPs that I'm actually taking on risk because I don't know what I'm doing!”

What Is a TIPS?

A TIPS is a Treasury Inflation Protected Security. It is a type of Treasury bond, i.e. a loan to the government. However, instead of getting a guaranteed nominal rate of return and then your principal back from the government, like you would with a regular old (nominal) Treasury bond, you get a guaranteed real (inflation-adjusted) rate of return with TIPS. Note that there is no guarantee that your TIPS (much less a mutual fund or an ETF that owns TIPS) is going to “match” inflation over any time period other than the full time period of the bond. And it's never going to beat inflation (as measured by the Consumer Price Index for Urban consumers or CPI-U) over that full-time period—especially once taxes are assessed if it is held in a taxable account. TIPS are considered riskless (obviously the government could default) in the long run, but they can be quite volatile in the short term.

More information here:

TIPS vs. Nominal Bonds

How Does a TIPS Work?

The Department of the Treasury explains:

“As the name implies, TIPS are set up to protect you against inflation. Unlike other Treasury securities, where the principal is fixed, the principal of a TIPS can go up or down over its term. When the TIPS matures, if the principal is higher than the original amount, you get the increased amount. If the principal is equal to or lower than the original amount, you get the original amount. TIPS pay a fixed rate of interest every six months until they mature. Because we pay interest on the adjusted principal, the amount of interest payment also varies. You can hold a TIPS until it matures or sell it before it matures.”

The fixed interest rate (coupon rate) on a TIPS is never less than 0.125%, but it's possible to buy one with a negative real yield either at a Treasury auction or on the secondary market. The minimum purchase is $100, and they can be purchased in any increment of $100. There are maximum purchase amounts when bought at auction too, but these limits are so high ($10 million+) that they are unlikely to affect a white coat investor.

The entire return on TIPS is taxed every year—whether it is from an interest payment or an increase in value—at ordinary income tax rates on your federal tax return. However, those earnings are state tax-free. The taxation of additional principal (added to the original principal due to inflation)—which you have not yet received and which is often referred to as phantom income—is a bit of a hassle, and it's one reason why many investors prefer to own their TIPS inside tax-protected accounts if at all possible (even though they lose out on that state tax benefit by doing so). TIPS are considered one of the less tax-efficient asset classes out there.

TIPS are currently available at auction in terms of five years, 10 years, and 30 years. You can buy a TIPS of many terms on the secondary market through a brokerage.

If you own a TIPS, you get an income distribution twice a year. If you bought a TIPS in October 2024, you would get paid in October and April of 2025, 2026, 2027, 2028, and 2029. In October 2029, you would get your principal adjusted upward with inflation returned to you.

When trying to understand how TIPS behave in varying market conditions, the most important thing to realize is that, just as the value of a nominal bond goes up and down with changes in nominal interest rates, the value of a TIPS goes up and down with changes in real interest rates. Since there is little to no creditor risk with these bonds, all of the volatility is due to the term (interest rate) risk. This varies with both nominal interest rates and expectations of inflation.

Where and How Do You Buy TIPS?

TIPS can be purchased in four different ways.

#1 Treasury Direct Auctions

TIPS can be purchased at auction directly from the government through the TreasuryDirect website. This is the least expensive method but probably the biggest hassle. These auctions are held in the following months:

5-year TIPS

• Original issue: April, October
• Reopenings: June, December

10-year TIPS

• Original issue: January, July
• Reopenings: March, May, September, November

30-year TIPS

• Original issue: February
• Reopening: August

Your money is generally transferred to the Treasury from your bank account on the last day of the month.

#2 At Auction Via Your Brokerage

TIPS can also be purchased at auction indirectly via your brokerage firm. Commissions vary, but they are generally quite reasonable. This may be the easiest and most convenient method to purchase individual TIPS, especially within a retirement account or a Health Savings Account (HSA) that allows for the purchase of individual securities.

#3 On the Secondary Market

Existing TIPS that have not yet matured are not quite as liquid as nominal Treasuries, but as bonds go, they are still very liquid and can be bought and sold any day the market is open through your brokerage. This would allow you to buy a 1-year or a 4-year or a 26-year TIPS if you so desired. This is the most flexible way to buy individual TIPS since you can purchase them at any time, not just at the time of an auction or an auction re-opening.

#4 Via a TIPS Mutual Fund or ETF

If you don't want to hassle with buying individual TIPS yourself or are investing in an account that does not allow you to do so, consider a TIPS mutual fund or ETF. There are many very inexpensive, passively managed TIPS funds of various maturities and durations. While only TIPS will be in the fund, there will be TIPS of a variety of vintages. For example, the Vanguard Short Term Inflation Protected Securities ETF (VTIP) owns 27 different TIPS.

How Is a TIPS Different from an I Bond and Which Is Better?

While both a TIPS and an I Bond are inflation-protected securities issued by the US government, a TIPS is a Treasury and an I Bond is a type of savings bond. They work differently, and each has its pluses and minuses as discussed in I Bonds vs. TIPS. Which is better depends on the interest rates at the time of issue, the movement of those interest rates during the period you own the bond (unknowable), and your personal goals for the money. `

Some advantages of TIPS include:

• Can be purchased in essentially any amount (there are significant limitations on I Bond purchases)
• Can be resold immediately (no requirement to hold for one year and no loss of interest for the first five years like I Bonds)
• Can be easily packaged into mutual funds and ETFs and made available in retirement plans
• Initial TIPS fixed rates are set by a market mechanism (the auction), not government fiat like an I Bond
• TIPS can be sold to anyone, not just the government
• TIPS can be easily laddered (see below)
• TIPS go up in value when interest rates fall

Some advantages of I Bonds include:

• They grow in a tax-protected way; no tax is due until they are sold
• They have better deflation protection than TIPS in that their principal never goes down in value: the value of a TIPS will never go below the original value, but you can lose the increase in value from previous years
• I Bonds used for higher education can be sold tax-free for low earners
• At times, I Bonds can have very high interest rates (as high as 9.62% at one point in 2022)
• I Bonds, like cash but unlike TIPS, don't go down in value when interest rates rise

More information here:

I Bonds, TIPS, S Corps, ETFs, and 403(b)s

Should I Buy Individual TIPS or a TIPS Bond Mutual Fund/ETF?

Some investors think it is silly to pay even a tiny fee to a mutual fund manager who is just going to buy TIPS for free from the government. In addition, when you buy individual TIPS, you know exactly when they are going to mature and how much (at least on a real basis) you are going to receive when they do. In exchange for the convenience and flexibility of a mutual fund or ETF, investors must pay a fee (generally very low) in the form of an expense ratio and face some additional risks.

The first risk is faced by any investor, whether an individual or fund manager, who must invest additional money into the asset class in the future. This is reinvestment risk. You might be forced to reinvest at lower interest rates when rates fall. When rates rise, you might lose principal if you try to maintain the same duration for your bond portfolio because you will be selling bonds that have lost value prior to their maturity. An individual bond held to maturity does not have that risk.

There is an additional risk unique to fund investors—the risk that other investors in the fund will panic-sell and force the fund manager to sell bonds while their value is low and lock in principal losses for the remaining investors. These risks should not be particularly concerning to the individual long-term investor, but if you are worried about them, the work-around (buying individual TIPS) is not too time-consuming, expensive, or risky.

While I think bond funds are appropriate for corporate bonds, mortgage bonds, and municipal bonds, I do see buying individual Treasuries (including TIPS) as completely reasonable. In fact, Katie and I own TIPS both directly through TreasuryDirect accounts and indirectly via the Schwab TIPS ETF (SCHP) in some retirement accounts.

What Is a TIPS Ladder?

A TIPS ladder, like a CD ladder, just consists of a series of TIPS with different maturities. For example, someone who wanted to invest $3 million in a 30-year TIPS ladder might put $100,000 into a 1-year TIPS, $100,00o into a 2-year TIPS, and so on until they get to a 30-year TIPS. When each TIPS matures, the proceeds are either reinvested into a new 30-year TIPS or spent for living expenses. Near retirees and retirees often construct TIPS ladders to reduce the risk of having to reduce their real spending amount each year in retirement.

Naturally, a 30-year TIPS ladder does nothing to protect you from running out of money if you live longer than 30 years. You would need a Single Premium Immediate Annuity (SPIA) to insure against that risk, but inflation-adjusted SPIAs are no longer available on the market. The closest thing you can find to buying one is to delay your Social Security benefits to age 70.

Why Didn't TIPS Keep Up with Inflation in 2022?

Many TIPS investors were frustrated in 2022 when inflation reared its ugly head and TIPS didn't provide outsized returns. They actually lost money. Remember that TIPS are bonds, and when interest rates go up, the value of a bond goes down. When nominal interest rates go up, the value of a nominal bond goes down. When real (after-inflation) interest rates go up, the value of an inflation-indexed bond such as a TIPS goes down. Real interest rates went up about 4% in 2022, so nobody should be surprised to see the value of a TIPS go down (way down for long-term TIPS) in 2022. I Bonds, with their principal guarantee, performed much better that year. TIPS still outperformed nominal Treasuries of comparable duration during the period of unexpectedly high inflation, although the outperformance wasn't dramatic.

• VTIP — Vanguard Short Term TIPS ETF (duration 2.37 years): -2.96%
• VGSH — Vanguard Short Term Treasury ETF (duration 1.88 years): -3.86%

The short term Treasury fund lost more than the short term TIPS fund despite having less term risk.

• SCHP — Schwab TIPS ETF (duration 6.71 years): -12.02%
• IEF—IShares 7-10 Year Treasuries ETF (duration 7.22 years): -15.16%

With similar durations (although IEF did have slightly more term risk), the TIPS ETF outperformed significantly. The biggest issue for all bonds in 2022 was the term (interest rate) risk. This is easily seen when you look at long bond funds.

• LTPZ — PIMCO 15+ Year US TIPS ETF (duration 18.8 years): -31.68%
• VGLT — Vanguard Long Term Treasuries ETF (duration 14.9 years): -29.35%

Had the duration of VGLT been the same as the PIMCO fund, it likely would have had losses of 40% or more. I looked but could not find a Treasury fund with a similar duration to compare to LTPZ.

If an investor had mistakenly thought that TIPS would protect them from losses during a time of high inflation or cause the portfolio to “keep up with inflation,” it is easy to see why there was so much disappointment. TIPS held to maturity guarantees you a real rate of return, but they are only riskless assets in the long term. In the short term, they can be pretty risky—especially the longer-term ones owned in a fund where the other investors tend to sell low in a bond market downturn.

More information here:

Inflation Is NOT Good for the Wealthy

Why You Must Adjust for Inflation in Long-Term Planning

The Bottom Line

While half of our bonds are inflation-indexed (TIPS and I Bonds), investing in TIPS is still optional for you. If you don't understand how they work, don't invest in them. But as a major asset class, I think it is worth taking a little time to understand the workings of nominal bonds and TIPS, their slightly more complicated cousins. If you're going to invest in bonds, you should give serious consideration to the bonds that address perhaps the most serious long-term risk (inflation), such as TIPs.

What do you think? Do you invest in TIPS? Why? How? Do you like them better than I Bonds?

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