Treasury Inflation-Protected Securities (TIPS)

Treasury Inflation-Protected Securities, sold and universally referred to as TIPS, are marketable US Treasury securities whose principal is adjusted for inflation and deflation. TreasuryDirect describes the mechanism directly: "Unlike other Treasury securities, where the principal is fixed, the principal of a TIPS can go up or down over its term," and "because we pay interest on the adjusted principal, the amount of interest payment also varies." Treasury sells them for terms of 5, 10 or 30 years, in a $100 minimum and $100 increments, paying interest every six months, and adjusts the principal using the Consumer Price Index.

The design point that follows from that is worth stating explicitly, because it is the reverse of how most people picture inflation protection working. The rate does not change. The base it is applied to does. A holder of an ordinary Treasury bond receives the same dollar amount every six months for the life of the bond; a holder of TIPS receives a payment that grows as the index grows, because the same fixed percentage is being applied to a principal amount that has been marked up. The protection is built into the size of the payments and the size of the final repayment rather than into the rate on the certificate.

The tax treatment is the reason TIPS need to be understood before they are bought. IRS Publication 550 states the rule for inflation-indexed debt: "If you hold an inflation-indexed debt instrument (other than a Series I U.S. savings bond), you must report as OID any increase in the inflation-adjusted principal amount of the instrument that occurs while you held the instrument during the year." So the annual increase in principal is federally taxable income in the year it happens, and none of it is paid out until maturity or a sale. In a year of meaningful inflation, a holder can owe tax on more than the cash the security actually produced, which is why TIPS held in a taxable account can create a cash-flow problem that a nominal Treasury bond does not. TreasuryDirect flags the same point in its own summary: "Any increase or decrease in the principal during the year may affect your federal taxes."

The parenthesis in that sentence from Publication 550 is doing a great deal of work. The Series I savings bond is written out of the rule by name. An I bond's inflation adjustment is not reported as it accrues; federal tax on it can be deferred until redemption or final maturity. That is the sharpest practical difference between the two inflation-linked instruments Treasury sells, and it is not visible from either one's rate.

The deflation floor exists, and it exists at maturity. TreasuryDirect states it as a rule about the final payment: "When the TIPS matures, if the principal is higher than the original amount, you get the increased amount. If the principal is equal to or lower than the original amount, you get the original amount." So the original principal is protected against deflation on the maturity date. Nothing protects the market price before then. TIPS are marketable securities, they trade at whatever buyers will pay, and a holder who sells early takes that price whether it is above or below what they paid. A description of TIPS as unable to lose money is describing the maturity payment and quietly extending it to the whole holding period.

Two rates get confused, and they are unrelated. The coupon rate is fixed at auction and, in TreasuryDirect's words, "is never less than 0.125%." The real yield bid at the auction is a different number, and Treasury's auction rules "allow for negative real yield bids." A negative real yield at auction does not produce a negative coupon; it produces a price above face value, so the buyer pays more than $100 per $100 of principal and the excess is absorbed over the life of the security. A holder buying at such an auction is accepting a return below inflation in exchange for having the inflation risk removed, which is a coherent trade rather than an error.

What TIPS do and do not hedge. They hedge the part of inflation that has not already been priced into nominal bonds, which is the surprise rather than the expectation. They index to headline CPI, so a household whose own costs are dominated by medical care, housing or tuition is not being tracked precisely. They are Treasury securities, so their prices move with real interest rates, which means a TIPS holding can fall in value during a period of rising rates even while inflation is running high. And their interest is exempt from state and local income tax like any Treasury obligation, so the tax problem is strictly a federal one, and it is one that largely disappears inside a tax-deferred account.

Treasury sets a fixed coupon rate at auction. Every day thereafter the principal is marked up or down by an index ratio derived from the Consumer Price Index. Every six months the coupon rate is applied to whatever the principal has become, and at maturity Treasury repays the greater of the adjusted principal or the original principal.

A hypothetical example, using invented inflation figures rather than any current ones. Marisol buys $10,000 of TIPS with a 1 percent coupon rate, paid in two installments of 0.5 percent each. Suppose the index rises 1.5 percent in each half of the year.

After six months the principal is $10,000 × 1.015 = $10,150. Her first interest payment is 0.5% × $10,150 = $50.75.

After twelve months the principal is $10,150 × 1.015 = $10,302.25. Her second interest payment is 0.5% × $10,302.25 = $51.51.

Cash received over the year: $50.75 + $51.51 = $102.26.

Reportable income for the year: the $302.25 increase in inflation-adjusted principal, reported as original issue discount, plus the $102.26 of interest actually paid, for about $404.51 in total.

So roughly a quarter of the year's taxable income arrived as cash and the rest did not. The $302.25 is real and it is hers, but she cannot reach it until the security matures or she sells, while the tax on it is due for this year. In a traditional IRA or a 401(k) the timing problem disappears entirely, because nothing inside those accounts is taxed as it accrues.

Now the deflation case. Suppose instead prices fall and the principal drifts down to $9,700 by the maturity date. Treasury repays the greater of the adjusted and the original principal, so Marisol receives her $10,000. Had she sold in the market at that point rather than waiting for maturity, she would have received whatever price the market set, with no floor of any kind.

Pros

• The principal tracks the Consumer Price Index, so both the interest payments and the final repayment keep pace with measured inflation rather than being eroded by it.
• At maturity the repayment cannot fall below the original principal, however long a period of deflation the security lived through.
• It is a direct obligation of the United States, so the inflation protection does not come attached to credit risk.
• Marketable and deep, so a position can be sold on any business day, unlike a savings bond with a holding restriction.
• Interest and principal adjustments are exempt from state and local income tax, like any Treasury obligation.
• Available in terms of 5, 10 and 30 years, so the protection can be matched to a horizon.

Cons

• The annual principal adjustment is federally taxable in the year it accrues even though no cash is received, which is the main argument for holding TIPS inside a tax-deferred account.
• The deflation floor applies at maturity only. Before then the price is a market price and a sale can be at a loss.
• Prices move with real interest rates, so TIPS can fall in value during a period of high inflation if real rates are rising at the same time.
• The index used is headline CPI, which may not resemble a particular household's own spending.
• Buying at a negative real yield locks in a return below inflation, which is the cost of the protection rather than a mispricing.
• It protects against inflation and against nothing else, so it is not a substitute for the growth assets a long plan usually needs.