The 2021 spike in inflation came as a rude awakening for a generation of investors who haven’t experienced the phenomenon since the early 1980s (or never for the younger set). For fixed income investors, inflation is an insidious foe that erodes purchasing power of otherwise less risky investments like U.S. Treasury bonds. For that reason, the Treasury created TIPS, or Treasury Inflation Protected Securities, that adjust automatically to protect the purchasing power of the cash flow stream. These bonds provide a hedge against rising prices and serve as a valuable tool in assessing the market’s expectations for future inflation.
The idea of inflation indexed bonds is not a new one. The first known examples were issued by the Commonwealth of Massachusetts during the Revolutionary War as compensation to soldiers in lieu of cash salary. Known as “soldiers’ depreciation notes,” they were intended to compensate payees for the loss of their purchasing power during the high inflation of the period. The concept enjoyed only limited success over the next two centuries until sovereign governments began adopting the concept after World War II. In 1997, the Treasury announced the creation of the first U.S. government bond indexed for inflation.
Traditional Treasury bonds pay a fixed interest rate (called the coupon rate) semiannually over the life of the bond. The payment is computed based on the rate and the principal face or par value of the bond. At maturity, the final coupon payment is received along with the par value.
With TIPS bonds, the coupon rate is also fixed and does not change. However, the principal value is adjusted up or down based upon changes in the Consumer Price Index. Inflation causes the principal to increase, while deflation causes the principal to adjust downward. Subsequent coupon payments are computed using the indexed principal values, which means that both the par value and the interest payments vary with price changes in the economy. TIPS are backed by the full faith and credit of the United States, just like conventional Treasury bonds.
The interest rate on these bonds is determined when the bonds are issued by the U.S. Treasury. This issue is conducted via a public auction conducted according to a published schedule and is open to any investor, although the bulk of the bidders are large dealer firms. The price determined by the results of the auction fixes the coupon rate for the duration of the issue. An example may help illustrate the process.
The Treasury department auctioned around $20 billion of new 10-year TIPS bonds in July. The bidding resulted in a final price of $99.01, which means $99.01 per $100 of face or par value. This discount from par translates into a coupon rate of 1.875%, the effective annualized rate of return each bidder would realize if they held the bonds to maturity and there was no inflation. Every six months, the investor would receive an interest payment of 1.875% of the principal value divided by two.
Now let’s look at how inflation works with TIPS bonds. Suppose you purchased $1,000 face value in July. In the absence of inflation, your interest payments would be $9.38 every six months ($18.75 annually). Now imagine that inflation in year 1 is 3%, roughly in line with the current rate. Next year, the principal value would index upward by 3% to $1,030 and your semiannual payment would increase to $9.66. If inflation held steady at 3% for the next 10 years, your principal value would increase to $1,344 and your final interest payment would be $12.59.
TIPS do come with a wrinkle in their tax treatment. As with regular treasury bonds, interest payments on TIPS are subject to federal income tax. But each year, the appreciation in principal value, referred to as “phantom income,” is also reported as taxable income on form 1099-OID even though no cash flow occurred. For this reason, a tax deferred account like an IRA is generally the best place to hold them.
TIPS are issued in five-, 10- and 30-year maturities and can be purchased through banks, brokers and directly from the U.S. Treasury at TreasuryDirect.gov. The minimum denomination is $100, and there is an active secondary market, providing investors with liquidity should they wish to sell their bonds. There are also TIPS bond funds that provide inflation protection but sacrifice the advantage that comes with the option to hold to maturity to guarantee against capital loss. It should also be noted that while TIPS protect against inflation, they are still subject to the same interest rate risk as regular treasuries.
Investors could certainly choose to purchase a traditional Treasury bond that is not inflation adjusted and hope that the higher coupon amply compensates them for inflation risk. A regular bond with the same 2035 maturity carries a coupon rate of 4.25% but no principal adjustment. The difference in yields between the traditional and TIPS bonds is called the breakeven inflation rate, the market’s expectation of average inflation over the life of the bonds. In our example, 4.250% minus 1.875% or 2.375% is the breakeven rate. If inflation runs hotter than 2.375% over 10 years, the holder of the TIPS bond will earn a higher real return than with the straight treasury bond.
The breakeven rate can be helpful to individual investors considering inflation adjusted bonds, particularly if they expect prices to rise faster. Despite the Federal Reserve’s current restrictive monetary policy, inflation has proved sticky at close to 3%, well above the 2% target. Meanwhile, a weakening job market is pressuring the Fed to cut interest rates even as higher costs from tariffs are increasing consumer prices. One conceivable consequence could be a limited version of the stagflation of the 1970s with inflation and economic weakness coexisting. In that scenario, a portion of a balanced portfolio in an array of TIPS could serve as a valuable insurance policy.
Christopher A. Hopkins, CFA, is a co-founder of Apogee Wealth Partners in Chattanooga.