Understanding TIPS: Do They Belong in Your Portfolio?

Christopher Moser is an investment consultant for Northwestern Mutual.

You probably already know that the best investment strategies all involve diversifying your portfolio based on your risk tolerance, investment timeline and financial goals. For most investors—from beginners to pros—that will usually include investing in both stocks and bonds.

If you’re new to fixed-income investing, you might not know that there are many different types of bonds or that different types of bonds are better suited to different roles in your portfolio. Investors looking for fixed income with tax advantages might, for example, incorporate municipal bonds into their investment strategy. And those concerned with preserving their buying power against inflation might instead choose TIPS bonds.

Below, you’ll learn what TIPS bonds are and how they work. You’ll see the potential benefits and disadvantages of including them in your portfolio while comparing them against similar bonds.

What are TIPS bonds?

Treasury Inflation-Protected Securities (TIPS) are a type of bond offered by the United States Treasury. They’re tied to an inflation tracker called the Consumer Price Index. TIPS bonds are specifically designed to help investors protect their purchasing power even when inflation runs high.

Here are some quick points:

• Available maturities: TIPS can last five, 10 or 30 years.
• Minimum amount: You can purchase TIPS in an auction from the U.S. Treasury if you have at least $100. They are available in increments of $100.
• Maximum investment: You could buy a maximum of $10 million in TIPS directly from the Treasury during an auction. You’d make a non-competitive bid meaning you accept the yield, rate or discount margin determined at the auction. (There’s no limit in the resale or “secondary” market.)

How do TIPS bonds work?

The U.S. Treasury publishes an auction schedule that details when different types of TIPS bonds will be available. You or someone working on your behalf can set up an account and get into an auction.

When you purchase TIPS bonds, you are essentially locking away your principal for five, 10, or 30 years. Then, every six months, that principal is adjusted up or down depending on the rate of inflation according to the Consumer Price Index.

The rate is fixed at auction and never goes below 0.125 percent. Because interest is paid on the adjusted principal, how much interest you earn will vary.

When the rate of inflation increases, so will the value of your TIPS bonds. But during periods of deflation—which have historically been rare in the United States—the value of your TIPS can also decrease.

After a few years, when the TIPS mature, you’ll get the final value of your principal. If the ending principal is higher than when you purchased the TIPS, you’ll receive that higher amount. If the ending principal is lower than the original principal, you’ll still get that original amount. So, you’ll never get less than what you paid in (unless you have to sell earlier than planned).

Are TIPS risky?

TIPS are considered a low-risk investment because they are backed by the United States government.

But TIPS do carry other types of risk:

• Deflationary risk: The principal on TIPS isn’t guaranteed to move up. It can go down during deflationary periods. While these aren’t common in the U.S., they do happen from time to time, including the Great Recession in 2009.
• Interest rate risk: If interest rates rise, the value of TIPS on the secondary market may fall. This means that it may be possible to lose money if you sell your TIPS before the full five, 10 or 30 years. You can eliminate the risk by keeping your TIPS the whole time, which is called “until maturity.” That leaves you with some liquidity risk because you could lose out if you have a major unexpected expense and need to get your money out of TIPS.

Why are TIPS popular with investors?

TIPS are popular with investors because they carry very little risk of default and little to no risk of principal loss—as long as they are held to maturity. And because they’re linked to inflation, they can act as a very effective long-term buffer for inflation, helping preserve buying power that would otherwise be eroded away.

Comparing TIPS and I Bonds

TIPS and Series I Savings Bonds, known as I bonds, are both Treasury securities designed to help you keep up with inflation. But they work differently.

With I bonds, inflation is accounted for via a shifting interest rate. When inflation rises, the interest rate rises alongside it. When inflation decreases, the interest rate decreases. But the face value of the bond (the principal) remains the same.

TIPS work the opposite way. The interest rate remains fixed until the bond matures, while the principal is adjusted up or down as necessary. These adjustments occur every six months for both TIPS and I bonds.

Some other important differences are:

• Purchase limits: As we mentioned earlier, you can purchase up to $10 million worth of TIPS directly from the Treasury at auction in a non-competitive bid—and an unlimited amount on the secondary market. But you can purchase only $10,000 worth of I bonds each year from the Treasury. Because they are non-transferable, I bonds cannot be sold on the secondary market.
• Liquidity: If you need to raise cash, you can sell TIPS at any time through the secondary market without penalty. I bonds are non-transferable. With I bonds, you are required to hold the bonds for at least one year after purchasing them. If you sell within five years, you will forfeit the interest you earned in the last three months as a penalty.
• Maturity periods: You can purchase TIPS that mature in five, 10, or 30 years. I bonds come with a 30-year maturity period, though you can sell them before that date.

How to buy TIPS

There are a few different ways to invest in TIPS.

You can purchase them directly from the U.S. Treasury through its website when auctions are held periodically through the year. You’ll need to invest at least $100 and follow the auction calendar.

Or you can purchase TIPS on the secondary market through financial institutions like your bank or brokerage firm. The exact process will vary. You’ll probably pay a transaction fee when you purchase TIPS on the secondary market—which will diminish your overall return.

You can also purchase shares of an exchange-traded fund (ETF) or mutual fund with a connection to TIPS. The funds will either invest only in TIPS or include them in a broader group of securities.

Advantages of investing in TIPS

The primary advantage of investing in TIPS is their low-risk way of generating income via interest payments, with an additional assurance that their principal is shielded from the worst effects of inflation.

Another benefit involves taxes. While federal income taxes are owed on income earned from TIPS, this income is exempt from state and local taxes. In states with particularly high income taxes—like California, Hawaii and New Jersey—this can lead to big savings over other non-tax-exempt fixed income assets.

Finally, remember that TIPS are more liquid than some other Treasury securities, like series I bonds. That’s because, unlike savings bonds, TIPS are transferable and can be sold on the secondary market if you need to get your money out.

Potential downsides of TIPS

Despite their benefits as an inflation hedge, TIPS do have some drawbacks.

For example, TIPS typically offer lower rates than you might find in other bonds—mostly because they are backed by the U.S. government and therefore carry little risk. They can be a good way to protect your money. Although hedges are an important part of any investment strategy, relying on them too heavily may result in significant opportunity cost.

Another consideration: If the principal of a TIPS is adjusted upward, income taxes are due on that increase in the year that it’s earned. That’s true even if you haven’t realized a gain by selling.

Although TIPS are more liquid than I bonds, it’s important to remember that these securities are sensitive to movements in interest rates. Depending on the rate environment you find yourself in when you sell TIPS (instead of holding them to maturity), you could lose money.

Are TIPS a good investment right now?

At the end of the day, TIPS can be an effective way of protecting your money against inflation. But whether they are a good investment for you will depend on a variety of factors, including your investment goals, risk tolerance and where you believe inflation is heading.

Your Northwestern Mutual financial advisor can help you consider your options. Together, you can look at the big picture and ensure that your investments match your needs. And your advisor can show you how your investments work with additional financial options, like permanent life insurance, to help you reach your goals.