TIPS – Treasury Inflation-Protected Securities

Fixed income plays an important role in an investment portfolio, especially for those investors who are dependent on current income or planning for future expenditures. Most bonds offer investors a fixed coupon for a specified period of time and provide a stated rate of return. A concern arises, however, when the investment earns 4% and inflation is running at 3%. This means that the real rate of return – the stated return minus inflation – is only 1%. A bond investor locks in the money for a period of time and commits to a specific income stream, but if he underestimates inflation, future proceeds from his investment may have less purchasing power.

Unlike nominal bonds, TIPS are designed to offer a real rate of return and, hence, provide investors a certain amount of protection against inflation*. By investing in TIPS, investors give up the certainty of a predictable income stream for the assurance that their investment will maintain its purchasing power in case of rising inflation. For that assurance, TIPS pay slightly lower interest rates than comparable maturity Treasury securities. Some investors choose to diversify their portfolios by purchasing both TIPS and nominal bonds.

Addressing purchasing power risk

TIPS have a stated maturity date and pay a fixed coupon rate. The principal value is adjusted every six months based on changes in the Consumer Price Index for all urban consumers, CPI-U. Since the coupon is paid on the outstanding principal value, the semi-annual payments will fluctuate as well. Increases in consumer prices are reflected in higher principal and interest payments to TIPS holders. Conversely, decreases in consumer prices have an opposite effect on principal and interest payments.

To illustrate, consider the following inflation scenarios on a hypothetical five-year TIPS with a 1.50% coupon rate.

Year Coupon Par Value Inflation Period Change in CPI Adjusted Principal Value Interest Payment
1 1.50% $1000 Inflationary +2% $1020 $15.30
2 1.50% $1020 Deflationary -1% $1010 $15.15
3 1.50% $1010 Inflationary +3% $1040 $15.60
4 1.50% $1040 Inflationary +2% $1060 $15.90
5 1.50% $1060 Inflationary +1% $1070 $16.05

The change in CPI-U is represented by a factor which is reflected in the adjusted principal value. New issue TIPS have a factor of 1.0. In an inflationary period the factor will go up; in a deflationary period it will go down. As the principal value changes, so do the interest payments. At maturity, a TIPS investor is paid either the adjusted or the original issued principal, whichever is greater. In the illustration above, an investor would receive $1,070 at maturity.

Investment highlights

Principal and Interest Variability – Since interest payments and principal value are linked to CPI-U, they may fluctuate over the course of a TIPS life, making it hard to project future cash flows. Investors looking for predictable cash flows should not rely on TIPS. However, including these bonds in a portfolio can be part of a well-established diversification strategy**.

Capital Preservation – Backed by the full faith and credit of the U.S. Government, TIPS are a good alternative for investors concerned about the quality of their bonds. Although TIPS are not as directly correlated to changes in interest rates as their nominal counterparts, they are still affected by those changes. The value of TIPS can fluctuate up or down with changes in interest rates. Investors who need to sell prior to maturity may be exposed to market risk and their proceeds may be more or less than the original investment.

Breakeven Inflation Rate – Depending on the inflationary environment, when comparing bonds investors should evaluate the difference in yields between TIPS and nominal Treasury bonds. The difference in yield is known as the breakeven inflation rate.

For example, if a 10-year TIPS yields .25% and a 10-year nominal Treasury note yields 2.25%, then the breakeven inflation rate is 2.00%. If inflation is higher than 2.00% over the life of the bond, then TIPS should provide a higher total return than conventional Treasuries with the same maturity. One must note that, historically, breakeven rates have been around 2.50%, which is the average rate of inflation since the introduction of TIPS in the mid-1990s.

Deflation Can Cause Loss of Value – Extended periods of deflation could cause TIPS’ principal amount to fall below par ($1,000). This would have a negative effect on investors who sell TIPS in the secondary market after a deflationary period. In addition, TIPS purchased with a high adjusted principal can lose value if the inflation factor goes down in the future. To assure positive return of principal, investors are encouraged to purchase newly issued TIPS or those with an inflation factor of less than 1.0. Investors who hold TIPS until maturity will receive a minimum of par or the inflation adjusted principal, whichever is higher.

TIPS vs. Nominal Bonds – TIPS and nominal bonds behave differently in regards to changes in inflation. In times of increasing inflationary pressure, nominal bonds will become less attractive as their fixed interest payments lose purchasing power. As inflationary fears abate or in a case of deflation, nominal bonds become more valuable on a real return basis. If inflation turns out to be less than anticipated, the total return on TIPS could actually be less than that on a comparable nominal Treasury bond.

When inflation is expected to rise, an investor may choose to invest in TIPS because they will become more valuable than the comparable nominal bonds. However, if an investor believes that inflation will fall or deflation will occur, the nominal bonds would present a better value.

Liquidity – Although the U.S. Treasury securities market is one of the largest and most liquid securities markets in the world, the secondary market for TIPS is not as active or liquid as the market for nominal Treasury securities. Lesser liquidity and fewer participants may result in wider spreads between bids and ask prices on TIPS than their fixed principal comparables.

Taxation – Semi-annual interest payments on TIPS are subject to federal income tax, just like payments on nominal Treasury securities. However, increases in a TIPS principal value, as a result of inflation adjustments, are also taxed as income in the year they occur, even though those increases are not realized until the TIPS are sold or mature. This is known as taxation of “Phantom Income.” Conversely, decreases in the principal amount due to deflation can be used to offset taxable interest income. Investors hoping to avoid possible tax liability of “Phantom Income,” should consider purchasing TIPS in a tax-deferred account. Investors are urged to consult with their own tax advisors with regard to their specific situation prior to making any investment decisions with tax consequences.

Negative After-Tax Cash Flow – In periods of high inflation, for high-tax-bracket investors (if purchased in taxable accounts) TIPS may result in a negative after-tax cash flow as the increase in principal value will exceed the net coupon payments.

Changes In CPI-U – Investors must understand that current changes in consumer prices are not indicative of future movements. Moreover, the three-month lag in CPI data used to calculate the CPI-U index change may have an impact on TIPS values in the secondary market. This is especially important when swings in CPI-U are significant and rapid.

Note: The hypothetical examples provided are for illustrative purposes only and not intended to reflect the actual performance or offering of any security.

*Rate of inflation is based on the Referenced CPI-U, which has a three-month lag.

**Diversification does not ensure a profit or protect against a loss.

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