A Hot TIP

Are you worried about inflation and want a hedge in case it bursts out of control?

If so, the US Treasury offers two types of inflation-adjusted bonds that are designed to protect against the risk of increasing inflation. The first are the better known Series I inflation bonds (aka, I Bonds) and I previously explained them here. The second are Treasury Inflation-Protected Securities (aka, TIPs) and in this note, I’ll explain how TIPs work and contrast them with I Bonds.

If you want the basics on bonds, read my explanation here.

What are TIPs?

With a TIPs bond, the interest rate is fixed for the entire term but the principal grows by the rate of inflation. This is in contrast with I Bonds where the principal is fixed but the interest rate (i.e., the “coupon” in bond parlance) resets to the current rate of inflation. Both types of bonds can protect investors from future increases in inflation but their mechanisms are different.

TIPs, like other bonds, make interest payments every six months for the term of the bond and then repay the principal at the maturity date. While the interest rate is fixed, the interest payments go up over the life of the bond as the payment is based on the new (inflated) principal value. That is, the principal resets every six months and the interest payment is based on that new principal amount.

At the end of 5, 10, or 30 years (they are available in those three maturities), instead of getting your original principal repaid as with a normal bond, you’ll be paid back a larger amount (depending on how much inflation there was over the intervening years).

Crystal clear?

A Simple Example

Let’s assume you buy a 30-year TIPs with an initial principal value of $100 and an annual interest rate of 2.0%.

• In six months, you’ll receive your first interest payment of $1.00 (half of the annual rate of $2.00).
• Let’s say current inflation is 6%. Your principal will now re-set to $103 (half of the annualized rate of inflation).
• In 12 months, the interest rate remains 2.0%, but you’ll receive ~$1.03 of interest, due to the principal now being $103. The principal will also re-set again.
• You get the idea… as time goes on, your interest rate of 2.0% remains fixed but the interest payment grows as the principal on which it’s calculated also grows with the rate of inflation.
• If inflation were to remain at 6% for the entire term, your principal repayment would grow to almost $600 at the end of 30 years. $100 would magically become $600 and, along with the increased interest payments, that’s your inflation hedge.

Interest Rate Comparison

The interest rate on TIPs is lower than other regular US Treasury bonds or I bonds. You’d expect this due to the growth in the principal value over time. To give you a sense of this, as of October 2023, current 30-year US Treasury bond rates are:

• plain vanilla:  5.0%
• I Bond:  6.9%
• TIPs:  2.6%

What about taxes?

Like all US Treasury bonds, their interest is exempt from state taxes. Otherwise, TIPs have an unfavorable tax treatment because, besides owing taxes on the interest income, you’ll owe taxes each year on the amount the principal has grown due to the inflation re-set even though you don’t receive any cash until the bond matures. For that reason, TIPs are often held inside of a retirement account where you don’t worry about taxes.

By contrast, I Bonds have a favorable tax treatment as you can defer the receipt of the interest (and the taxes due) until the bond matures.

Why aren’t they in the news like I Bonds?

As you can infer from my dense explanation, TIPs are hard to understand. Also, unlike I Bonds where the interest rate is high, TIPs have a low interest rate so they’re not very newsworthy.

Are they a good deal?

As with lots of personal finance questions, the answer is, maybe, depending on your circumstances and investment goals. Like I Bonds, they’re a good inflation hedge. If you believe that future inflation is going to be high and remain so, then, yes, they’re likely to turn out to be a good investment; if you believe the current bout of inflation is transitory and we’ll soon return to low inflation and near-zero interest rates, then I’d stay away from them. In that scenario, you’d do better investing in plain vanilla long-term Treasury bonds.

If you want to have some insurance against future inflation spikes, then add some TIPs to your portfolio stew. However, if you try to explain them at your next social gathering, expect eyes to glaze over.

Another way to think about them is that you can lock in a real return (i.e., net of inflation) of ~2.5% over 30 years with essentially no risk. That’s a pretty good deal for an insurance policy against high inflation. If inflation turned out to be low and the nominal return of these bonds was modest, you should be happy anyway as your purchasing power was protected. That’s how a good hedge should work.

How can you invest in them?

TIPs are easier to invest in than I Bonds. As with I bonds, you can buy and hold them at TreasuryDirect.gov, but you can also buy them directly in a brokerage account. A third way to indirectly own them is to purchase shares in a mutual fund (or ETF) that just owns TIPs. That’s how I do it as it’s simpler than buying (and selling) individual bonds. Also, unlike I Bonds, there is no practical limit to how much you can invest.

If you’re worried about future inflation, TIPs are a good insurance policy. I Bonds are easier to understand and the tax treatment is a bit more favorable but, if you want more than a $10,000 per year of inflation insurance, sprinkle some TIPs in your IRA.