Inflation can put a real dent in your purchasing power. It can also chip away at your investments. Treasury Inflation-Protected Securities (TIPS) are investments that can help soften the impact as their interest yield goes up when inflation is high and drops when it's low.
That can be helpful during times of high inflation, which is why TIPS could be a good addition to add to your investment portfolio. They're also low-risk investments that are inherently stable because they're issued and backed by the U.S. Treasury.
How Do TIPS Work?
This type of U.S. Treasury bond is indexed to inflation. When inflation is on the rise, the principal value increases (and vice versa). TIPS dole out a coupon payment every six months at a fixed rate, but payments will fluctuate because the principal amount goes up and down with inflation. You'll receive a higher payout when inflation is up, and a lower payment during periods of deflation. They're issued in five-year, 10-year and 30-year terms.
On the whole, returns are generally lower when compared with riskier securities such as stocks, but TIPS offer stability and income over the long term. Upon maturity, the investor will receive either the adjusted principal or the original principal—whichever is more.
TIPS are available for purchase through TreasuryDirect. You can also buy them through a broker or bank. If you decide not to hold a TIPS bond through its full maturity date, you can sell it on the secondary market. (Just know that this could result in a potential loss.) If you're looking for extra diversification, you might explore a TIPS mutual fund or exchange-traded fund. Each includes a mix of different inflation-protected securities you can use to widen your investments.
So how much can you expect to earn with TIPS? Again, it has everything to do with the current rate of inflation and the bond's coupon rate (this is the interest rate that the bond pays). To calculate your semiannual interest yield, take the following steps:
- Find the index ratio for your TIPS through TreasuryDirect. It should correspond to the interest payment date.
- Multiply the index ratio by the original principal amount to determine your inflation-adjusted principal.
- Multiply that amount by half of the coupon rate.
How Are TIPS Different From I Bonds?
On the surface, TIPS work similarly to Treasury I bonds (also called Series I savings bonds), but the two assets determine yields differently. Series I bonds actually use two interest rates: One is fixed, and the other can fluctuate with inflation. When they are taken together, it's called a composite rate. The composite rate for Series I bonds issued from May 2022 to October 2022 is 9.62%. However, there are purchasing limits—$15,000 in electronic and paper bonds per calendar year. TIPS allow for much higher limits that are a non-issue for the average investor.
Instead of offering interest payments along the way, Series I bonds accrue interest over time that you'll receive upon redemption. They differ from TIPS in that they're only sold individually. You can't buy into a mutual fund or exchange-traded fund that specializes in Series I bonds. You also can't sell them on the secondary market. Instead, you can redeem them through the Treasury or wait for them to mature.
There are some key tax considerations as well. With TIPS, income payments and inflation adjustments are both subject to federal income tax. Series I bonds are different in that you won't owe taxes on your interest until the bond matures or you sell it.
Both Series I bonds and TIPS offer some protection against inflation, albeit in different ways. Series I bonds are geared more toward long-term investing, while TIPS can be bought and sold with more flexibility. TIPS also provide interest payments as you go, while Series I bonds don't offer the same kind of liquidity.
What's right for you will depend on your investing style. You can certainly hold both, though you might be better off investing in one or the other, then balancing your portfolio with higher-risk assets that may generate better returns over time. Your personal risk tolerance, financial goals and investment timeline can help you determine the right asset allocation for you.
The Bottom Line
TIPS could be worthwhile investments if you're hoping to maintain your spending power in the face of inflation. That being said, TIPS generally do not produce returns that are as robust as higher-risk assets including stocks. Striking the right balance within your portfolio will likely require a mix of both high- and low-risk investments.
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