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One of today's most pressing economic concerns is inflation. High levels of inflation can erode your savings and investments over time.
Investing in Treasury Inflation-Protected Securities, or TIPS, can help combat inflationary pressures on your investment portfolio. TIPS are U.S. Treasury bonds that protect against inflation.
What are TIPS?
TIPS mirror the movements of the consumer price index. This means that the principal you invest in TIPS will rise and fall with inflation and deflation over time. The CPI, a commonly used measure of inflation monitored by the U.S. Bureau of Labor Statistics, keeps tabs on average price changes for a basket of goods and services.
Savant Wealth Management financial advisor Allison Alexander says TIPS are especially attractive right now, as they act as a “defensive type instrument in a rising interest rate environment."
“The beauty of the TIP is that the instrument varies with the rate of inflation, so it really protects the purchasing power of the bond holder,” says Alexander, based in Rockford, Illinois. “TIPS are holding up and doing better relatively in this rising interest rate environment we find ourselves in."
Do TIPS belong in your portfolio?
A common rationale for investing is to preserve or grow the value of your money with the aim of protecting it from inflation. With this in mind, here’s what to consider before adding TIPS to your portfolio.
Benefits of TIPS
The ability to keep up with inflation is a key benefit for those with a more conservative outlook, such as retirement investors, who want to simply maintain their purchasing power (as opposed to growing it as much as possible). The structure of TIPS means that investors can keep their principal investment safe under all circumstances. Even if there is deflation, investors will receive their original principal instead of a reduced amount.
Since TIPS are issued by the U.S. Treasury and backed by the full faith and credit of the U.S. government, they are considered low-risk investments. Additionally, there is a secondary market available for TIPS so investors can sell their securities, if needed.
Drawbacks of TIPS
With most investments, the higher the risk, the higher the return. Since TIPS are low-risk securities that guarantee your principal, they garner lower interest rates and returns compared with other bonds, including other government bonds. So while TIPS can help investors maintain their purchasing power, investors may need to look for higher-yielding asset classes if they want to beat inflation. If inflation doesn’t rise as high as expected, TIPS will likely lag behind other investments.
» An alternative to TIPS: I bonds
Also, note that inflation adjustments and interest earned are considered taxable income for federal tax, although they avoid state and local income taxes. To help minimize the tax impact, investors can purchase TIPS in tax-advantaged accounts rather than in taxable brokerage accounts.
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How do TIPS work?
When investing in TIPS, you’ll receive semiannual, fixed rate interest payments (called coupon payments). Since your invested principal moves with CPI over time and is multiplied by the fixed interest rate, your interest payments also adjust with inflation.
To figure out what your inflation-adjusted principal and interest payments will be, the Treasury supplies TIPS Inflation Index Ratios. To use them, follow these steps:
Find your TIPS (using its CUSIP number, a 9-character unique identification code provided along with the terms of your bond) to identify the corresponding index ratio for a specific index date.
Multiply the index ratio by your original principal amount to determine your inflation-adjusted principal.
Multiply your inflation-adjusted principal amount by one-half of the security’s coupon rate (the annual interest payment) to calculate each semiannual interest payment.
Upon maturity, you’ll collect either your original principal or the adjusted principal amount, whichever is bigger.
How to buy TIPS
If you’d like to allocate some of your portfolio to TIPS, you can buy an assortment through a fund or purchase individual securities directly.
Investors can conveniently access a diversified collection of TIPS through one vehicle by using exchange-traded funds or mutual funds. Funds buy and sell securities of varying terms and reinvest proceeds into new TIPS as each one comes due. However, compared with holding individual bonds with a definitive maturity date, holding TIPS funds can be more volatile. Depending on when you sell your shares in the fund, you may receive more or less than you invested.
Generally, inflation-protected ETFs can be more of a pure play in TIPS as many invest solely in TIPS whereas inflation-protected mutual funds may also include other investments known to have inflation-fighting characteristics.
You can purchase individual TIPS through your brokerage account or by using the U.S. Treasury Department’s website, TreasuryDirect, which allows investors to directly purchase and hold individual securities.
Individual TIPS are available to be purchased in multiples of $100 and with varied terms — 5, 10 or 30 years. The Treasury sets the price and interest rate using an auction process. You can choose to hold your TIPS until maturity or sell them prior to their maturity date.
» Learn more: How to buy bonds