Buying Inflation Protection Is Tempting. What to Know About TIPS.
Lingering inflation is driving some investors into bonds that protect against price increases. Without careful consideration, investors could end up paying more than they bargained for.
Treasury inflation-protected securities, known as TIPS, are bonds whose principal value adjusts with changes in consumer prices, ensuring investors maintain their purchasing power. Lately, TIPS yields have neared their highest levels of the past two decades, attracting many who are worried that tariffs, deficits and deportations could fuel a new bout of inflation .
But TIPS have unique characteristics that mean investors should do some preparation before shopping. Here’s what to know:
What are TIPS?
TIPS are U.S. government notes and bonds, but with a key difference. While most Treasurys have a set principal that returns to investors when the bond matures, the principal of TIPS changes with the consumer-price index. Add in a fixed rate of interest paid semiannually, which is applied to the changing principal, and investors can ensure their money will keep pace with rises in the cost of living for years and decades to come.
Some financial advisers said TIPS offer similar benefits as I bonds , but without the $10,000 cap that limits I-bond purchases. Many recommend TIPS for older investors seeking capital preservation over investment returns.
“People close to retirement should seriously consider TIPS because unexpected inflation is a bigger risk for them than low inflation,” said Wade Pfau, author of the Retirement Planning Guidebook.
What are the risks?
Currently, TIPS yields are at levels not seen since the late 2000s. But they can also come with unexpected costs, and can suffer surprising losses.
Like all government bonds, TIPS are volatile if interest rates move sharply. Many investors who rushed into TIPS when inflation jumped in 2021 learned that the following year, when the Federal Reserve began raising rates. TIPS declined in value by about 12% counting price changes and interest payments that year, and investors pulled a net $37.2 billion from TIPS funds in 2022 and 2023 combined, according to Morningstar data. (Such market-value declines are only temporary for investors who hold TIPS to maturity, when they receive their principal, along with the inflation adjustments.)
At the same time, investors must pay federal taxes on both interest payments from TIPS and unrealized gains in principal, even though they don’t receive those gains until they sell or the bond matures. That can be years down the road. For that reason, advisers recommend holding TIPS in a tax-advantaged account such as a Roth IRA.
How do I buy TIPS?
A brokerage account can also help build what advisers call a “bond ladder.” That means buying bonds that mature sequentially over a series of years, ensuring a steady stream of inflation-adjusted income. The downside is assembling a ladder can be complicated and time consuming: A brokerage’s bond-trading desk can help, or websites including tipsladder.com or tipswatch.com .
Buying TIPS yourself also avoids mutual-fund fees, and holding those individual TIPS to maturity means investors have little to fear from changes in rates.
What about funds?
TIPS mutual- and exchange-traded funds offer a simpler way to invest. They spread your money across many TIPS, reducing the need to manage individual maturities. They have also become a popular option for minimizing taxes—since funds distribute taxable income rather than leaving investors on the hook for unrealized principal adjustments.
“If you don’t have a good idea of your investment horizon, use the ETF, because you can make your decisions later,” said David Merkel, president of Aleph Investments, LLC.
One thing to keep in mind: Putting money in a fund might be less appealing to investors worried about price volatility. Holding individual bonds to maturity means investors can ignore price swings. Most funds, which hold a large collection of bonds, don’t mature.
One way to reduce this risk is by investing in short-term TIPS funds, which focus on bonds maturing in five years or less. The shorter time until maturity makes the funds less sensitive to fluctuations in rates. Investors have poured a net $149 million into short-term TIPS funds so far this year, even as they pulled $127 million from TIPS funds overall, according to Morningstar.
“With short-term TIPS, you get the same inflation adjustment but with much less interest rate volatility,” said Eric Jacobson, senior principal at Morningstar.
What about political concerns?
Though U.S. Treasurys are typically considered the safest investments, some investors are worried that rising deficits and looming debt-ceiling battles could hurt their value, or even spur a delayed payment or default, said David Enna, owner of Tipswatch.com.
The U.S. has never defaulted on its debt, and most on Wall Street believe lawmakers won’t allow that to happen. However, even the risk of a default can fuel market volatility and push bond yields higher.
Despite these concerns, investors should remain focused on their long-term strategies, said Morningstar’s Jacobson. For now, it isn’t worth factoring the probability of a default into your plan.
Write to Imani Moise at [email protected]