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What are Treasury Inflation-Protected Securities (TIPS)?

Treasury inflation-protected securities can provide retires with some protection against inflation. But, you need to know the potential risks before choosing to include them in your portfolio.

Created to preserve purchasing power by protecting investors against inflation risk, treasury inflation-protected securities, or TIPS are Treasury bonds indexed to inflation.

Although TIPS can potentially give investors some protection against inflation, they don't work the same as conventional bonds. Before considering these instruments, retirees and pre-retirees must understand both the benefits and pitfalls.

TIP defined

A TIP is a bond issued by the U.S. Treasury whose face value ties to the Consumer Price Index. Adjustments made to TIPS track changes in the rate of inflation. After an adjustment, Treasury pays interest on the bond's adjusted face value. As long as inflation goes up, holders receive a gradually increasing stream of interest payments.

When the bonds mature, investors in TIPS get the bond's original face value, along with the sum of all inflation adjustments made since issuance.

In the case of deflation, this scenario reverses. The face value and interest payments decrease in a deflationary environment. However, TIPS will still keep up the new lower cost of goods and services.

Some investors like TIPS because they offer "real" rates of return. A real rate of return is when the actual return of an investment contemplates inflation. Contrast this with a traditional bond offering so-called "nominal" returns.

Regular Treasury securities have a fixed face value until the maturity date, with zero adjustments for inflation.

The underlying idea behind TIPS is to protect the purchasing power of cash over a long period.

What are the benefits of TIPS?

TIPS are popular with many in the bond crowd because they seem more stable due to their relatively low market risk. As Treasury bonds, TIPS are backed by the U.S. government.

TIPS may eliminate a lot of inflation risk in a portfolio in an inflationary environment since they index to the CPI.

TIPS are not for everyone

Many people understand the erosive force of inflation, especially when it comes to saving for retirement. Investors in TIPS see them as something that could provide a buffer against inflation risk. However, if you are thinking about adding TIPS, you need to discover more about them, including what factors influence their price and yield.

There are some possible downsides to putting money into a TIP.

  • A steeper learning curve. Many investors do not have a full understanding of Treasury inflation-protected securities and how they work. TIPS work and perform quite differently from typical bonds. Investors may need to spend more time understanding the mechanics.
  • TIPS tie to the Consumer Price Index (CPI), which tends to understate inflation.
  • Historically, TIPS underperform regular Treasuries. Such underperformance often occurs in situations where deflation is an issue.
  • Volatility. During market downturns, TIPS are often much more volatile than cash.

No guarantees.

  • Although TIPS are sometimes touted as "safe money" investments and are often found in older Americans' portfolios, they are not guaranteed, as are vehicles such as annuities.

Nobel-prize winning economist Robert Merton includes TIPS in his retirement portfolio. Merton believes TIPS can provide a positive return, adjusted for inflation when used in a long-term strategy.

TIPS may make sense for some retirees and pre-retirees. However, investors must do careful and thorough research before purchasing these Treasuries.

Retirees interested in TIPS should partner with a financial advisor who understands how TIPS work, as well as their potential downsides

TIPS is not a substitute for using multiple bonds and bond funds to achieve broader bond diversification. While they are a type of fixed-income investment, they do not work the same as regular bonds or funds invested in corporate bonds.

Talk with your advisor to see if TIPS are a viable addition to your retirement plan based on your goals and risk tolerance.

By Harry J. Abrahamsen Abrahamsen Financial Group