TIPS (Treasury inflation-protected securities) are government-issued bonds that are inflation-indexed. TIPS can thus yield higher returns as inflation rises than non-inflation-linked bonds. TIPS prices adapt to retain their real value when inflation rises. This makes them attractive to investors, especially when the economy is struggling or the threat of inflation looms. TIPS appears to be a natural choice for many investors when there is above-average uncertainty regarding inflation and market returns.
Unfortunately, TIPS do not always perform as advertised because most consumers do not fully comprehend this investment.
TIPS frequently outperforms traditional treasuries.
TIPS are comparable to other government securities marketed by the US Treasury in many aspects. They pay yearly interest and, like Treasury bonds, are guaranteed by the complete confidence and credit of the United States government. The key distinction is that the face value of a TIPS bond is changed following the official consumer price index (CPI). The face value of TIPS increases in proportion to the CPI.
This appears to be a fantastic deal on the surface. Inflation, after all, takes away nominal interest payments. TIPS face value increases imply that interest payments rise in line with inflation. TIPS are thus seen as safer, lowering their projected returns due to the risk-return tradeoff. TIPS aren’t the only securities that account for inflation. In addition, standard Treasury bonds carry an implicit inflation adjustment.
TIPS Efficiency
If markets forecast 3% inflation over time, that assumption is priced into the bond market. Investors base their selections on whether they believe inflation will be higher or lower than what a security’s price indicates. This affects TIPS and ordinary Treasury bonds, although TIPS are less likely to win this trade.
TIPS will outperform Treasury bonds in this scenario only if the declared CPI is higher than the market expects. Several important economic theories, such as reasonable expectations and efficient markets, indicate this is improbable.
On the other hand, TIPS has very significant concerns during times of financial hardship, when standard Treasury bonds shine brightly. The issue stems from how the government built the TIPS deflation floor, and the TIPS principal will not fall below the original value, according to the Treasury.
However, further inflationary adjustments can be reversed if deflation occurs. As a result, newly issued TIPS provide significantly higher deflation protection than older TIPS with the same maturity date. ETFs that invest in TIPS, like the iShares TIPS Bond ETF (TIP), have fallen when deflation has become a concern, as it did in 2008 and March 2020.
The Consumer Price Index (CPI) may not accurately reflect your actual inflation rate.
There are grounds to assume that inflation for elderly and even middle-aged Americans may be higher than official data indicate. These are also the categories that are more inclined to purchase TIPS. Initially, the CPI measured a set basket of products. However, because customers frequently migrate to cheaper new items, inflation figures based on a constant basket of commodities are generally exaggerated. The CPI has been revised to reflect these changes by the Bureau of Labor Statistics (BLS).
Many people get more set in their ways as they become older, making them less likely to convert to new products. Some of their resistance is rational since they have less time to recover their investments in learning new methods. Retirees wanting to conserve income with TIPS are the least likely to make substitutes, so they end up with higher inflation.
Substitution may appear to be a small impact, but consider how powerful it may be. Some retirees seeking TIPS protection continue to use landline phones rather than VoIP or cellphones and cable TV rather than streaming video, and these expenses might quickly mount up. Most importantly, retirees may continue to reside in less inexpensive neighborhoods.
TIPS Prices Are Fluctuating
TIPS has been dubbed the “only risk-free investment” because of its principal protection and inflation protection features. However, price volatility is a crucial risk signal, and TIPS frequently falls short in this area.
TIPS ETFs’ large price swings during the 2008 and 2020 stock market disasters demonstrate that their short-term stability is inferior to cash. Furthermore, TIPS with high cumulative inflation incorporated into their pricing may suffer huge losses if a deflationary slump occurs.
Is it possible for the total return on TIPS to be negative?
TIPS pay a fixed rate but alters the face value based on inflation. Total returns can be negative if interest rates climb to the point that the price of a TIPS falls enough to negate the CPI inflation adjustment.
What’s the Distinction Between TIPS and I-Bonds?
TIPS and I-Bonds are both inflation-indexed government securities. TIPS are available in various maturities and can be bought and traded at any time of day. On the other hand, Series I-Bonds are 30-year government savings bonds that can only be sold after one year. An individual can only buy $10,000 worth of I-Bonds in a given year, with a $25 minimum purchase.
TIPS Are Taxed In What Way?
TIPS interest income is taxed as regular income. Capital gains and losses on the bond are calculated based on the holding period (long-term capital gains are subject to tax). TIPS are sometimes free from state and municipal taxes.
Where Can I Purchase TIPS?
TIPS can be purchased online using a TreasuryDirect account with the US Treasury. You may also buy mutual funds or ETFs that specialize in holding TIPS through your broker.
Knowing their possible problems is a good idea. Understanding how TIPS operate is essential for properly using them in your portfolio.