Inflation-Protected Securities: Should You Consider TIPS?

Inflation eats away at your money, whether you notice it or not. One year, your grocery bill is manageable; the next, you’re wondering if you accidentally bought caviar. Enter TIPS (Treasury Inflation-Protected Securities) – bonds designed to keep up with rising prices. Sounds great, right? Well, not so fast. Let’s break down what they are, when they make sense, and what else you can do to protect your money.

What Are TIPS?

TIPS are U.S. government bonds that adjust for inflation. Regular bonds pay you a fixed interest rate on a fixed principal. TIPS, on the other hand, have a principal that rises with inflation (as measured by the Consumer Price Index, or CPI). When inflation goes up, the principal increases, and so do your interest payments (since they’re based on a percentage of that principal).

If inflation drops – or if deflation occurs – your principal shrinks. That means your interest payments shrink too. The good news? At maturity, you get either the original principal or the inflation-adjusted amount—whichever is higher. So while deflation can hurt, you won’t walk away with less than you initially put in (unless you sell early).

How Do They Compare to Regular Bonds?

• Regular bonds give you predictability. If inflation spikes, their fixed interest payments lose value.
• TIPS adjust with inflation. But if inflation is low, you’re getting lower returns than regular bonds.
• TIPS are still bonds. If interest rates rise, their market value drops, just like any other bond.

TIPS also have something called real yield, which is their return after accounting for inflation. Unlike regular bonds, which have a nominal yield (set interest rate), TIPS offer a real yield plus inflation adjustments. If real yields are negative, that means investors expect inflation to eat up more than they’ll earn – making TIPS a less attractive option.

Who Should Buy TIPS?

TIPS can make sense if you:

• Hate inflation. If you’re worried about prices skyrocketing, TIPS ensure your investment keeps pace.
•  Want a safe, low-risk investment. They’re backed by the U.S. government, which, last we checked, isn’t going anywhere.
•  Have a long-term mindset. TIPS work best when held to maturity. Selling early exposes you to price swings.
•  Are nearing retirement. TIPS are often recommended for retirees who need to protect their purchasing power as they start drawing from their portfolios. If you’re living off your savings, you don’t want inflation eating away at it.

They might not be a good fit if you:

• Want high returns. TIPS aren’t going to outpace the stock market or other investments with higher risk.
  Think inflation will stay low. If inflation barely moves, you’re better off with a regular bond that offers a higher starting yield.
  Need liquidity. Trading TIPS before maturity can be tricky, and price fluctuations might mean you sell at a loss.

Tax Considerations

TIPS come with an annoying tax wrinkle: you’re taxed on the annual increase in principal before you actually receive that money. Even though you don’t see that inflation-adjusted growth until the bond matures, the IRS considers it taxable income in the year it happens. This is known as phantom income and can be an unpleasant surprise if you’re holding TIPS in a taxable account. To avoid this, many investors buy TIPS in tax-advantaged accounts like IRAs or 401(k)s.

Inflation Expectations Matter

TIPS aren’t just affected by actual inflation—they’re also driven by what the market expects inflation to be. If inflation expectations go up, the price of TIPS rises. If inflation expectations fall, TIPS prices drop. This is different from the CPI adjustment built into the bond itself – it’s about how much investors think inflation will rise in the future.

Translation? If inflation comes in lower than expected, you might not see the kind of returns you were hoping for.

Alternatives to TIPS

If inflation protection is your goal, TIPS aren’t your only option. Here are some alternatives:

• Series I Bonds – These work similarly to TIPS but offer a fixed rate plus an inflation adjustment. The catch? You can’t cash them out penalty-free for five years.
• Commodities – Gold, oil, and other real assets tend to rise when inflation does. But they’re volatile, so don’t put all your money there.
• Stocks – Over time, good companies raise prices along with inflation. Equities generally outpace inflation, though the ride can be bumpy.
• REITs (Real Estate Investment Trusts) – Real estate values and rents typically increase with inflation. A well-managed REIT can provide both income and inflation protection.

The Bottom Line

TIPS aren’t magic, but they do their job – keeping your money from shrinking when inflation spikes. If that’s your priority, they’re worth considering. Just don’t expect big returns, and be ready to hold them until maturity. Otherwise, you’ve got plenty of other ways to fight inflation. Pick the right tool for the job, and don’t overcomplicate it.

Want inflation protection and growth? Balance things out. Some TIPS, some stocks, maybe a little real estate. Because the only thing worse than inflation is realizing too late that you bet on the wrong hedge.