Treasury Inflation-Protected Securities, or TIPS, are bonds issued by the U.S. Treasury. They’re ideal for those investors seeking protection against the corrosive forces of inflation — the great wealth destroyer.

TIPS are tied to the rate of inflation and pay investors a fixed interest rate as the bond’s value rises or falls with the inflation rate. TIPS provide a great way to diversify an investment portfolio. Plus, you get a product backed by the U.S. government.

What’s Inflation, Again?

Inflation, the rise in the prices for goods and services, happens every day. We see inflation working its insidious ways in higher gas and food prices that change virtually overnight and in out-of-control college tuitions and home values that play out over years and decades.

Inflation sucks, especially if you’re saving up for retirement. That $500,000 nest egg you have so carefully nurtured until now won’t be worth that amount 20 years down the road (if it remains static). In other words, over two decades with a 2 percent annual inflation rate, $1 would be worth only 67 cents. That means your $500,000 kitty would be worth only $335,000 in 2039.

How Do Treasury Inflation-Protected Securities Work?

At first glance, TIPS are no different than regular Treasury bonds. They pay interest twice a year on a fixed rate, which the federal government sells to investors to raise cash to keep the crazy machine that is America rolling along, whether it be for the mighty U.S. military or a border fence to keep out desperate woman and children.

Sure, Washington raises money via income taxes and other levies, but like most of us, the government needs more money to cover its bills.

Think of Treasuries as Uncle Sam’s unlimited credit card. China and Ireland (Ireland!) are some of the biggest buyers of U.S. Treasury bonds, which sell for 10-, 20-, and 30-year durations.

In exchange for buying bonds, investors make money via what is called the yield, which is basically the interest rate plus the compounding effect. The longer the bond duration, the higher the yield.

That said, TIPS differ from ordinary Treasuries in that they pay interest to investors not based on any time horizon but on the ebb and flow of inflation as measured by the Consumer Price Index (CPI).

The CPI reflects the monthly measurement of the prices of some 80,000 consumer items and services. However, this excludes home prices.

There’s also a second CPI to measure inflation called the core CPI. This further excludes food and energy costs, which are considered volatile (they rise and fall too much). The Federal Reserve sites core CPI when deciding whether to hike or cut interest rates.

How Do TIPS Work? Part 2

TIPS are issued for durations of five, 10, and 30 years. Currently, the Treasury Department — from whom you can buy TIPS directly online — is offering a coupon rate of 2 percent (the interest rate).

To get a clear understanding of how TIPS work, you need to do the math. For example, let’s say you invest $10,000 in TIPS bonds with that 2 percent coupon rate on January 1. That means in the first year, you’ll earn $200, paid semi-annually on June 30 and December 31. Your year-end balance is $10,200.

Let’s say at the end of Year 1, the CPI comes in at 3 percent. That means in Year 2, you apply the 3 percent coupon rate on the $10,200 principal to earn $300. Now your new balance is $10,500. And so on.

Just remember the CPI affects only the principal of your investment, not the interest you’ve earned. As this process plays out for 10 or 30 years, the magic of compounding interest takes over. And once the bonds mature, the investor should receive a much larger principal amount based on the years of applying the CPI.

Recapping the Benefits of TIPS

TIPS offer several benefits for investors — especially those folks who are saving for retirement and for the long term. To be honest, buying TIPS as a short-term investment makes no sense. To truly appreciate the power of TIPS, you have to be in for the long haul, which is pretty much the fundamental foundation of smart investing, anyway.

First and foremost, TIPS’ claim to fame is that they offer a hedge (protection) against the evils of inflation.

TIPS also can help to diversify a portfolio because these specialty bonds aren’t correlated to stocks or regular bonds (i.e., TIPS zig while stocks and regular bonds zag).

TIPS aren’t risky bets because investors are backed by the safety and security of the loving and benevolent federal government. (Uncle Sam would never cheat you, would he?)

Lastly, TIPS give investors trading flexibility. They can buy or sell the bonds before maturity.

 

The Downside of TIPS

The bonds’ net-asset value, or its face value, can decline during bouts of deflation or economic uncertainty. And TIPS, like most bonds, are sensitive to interest rates. When rates rise, in most cases, so do bond yields. And bond prices usually fall. Investors who sell during such volatile periods before maturity will take a hit.

TIPS have another rub, as well — taxes. The IRS considers the annual increase in the bond’s principal value as taxable income in the year that interest payment is received, even though you can’t touch those annual increases until the bond is sold or matures, which could take three decades. That’s why TIPS should be purchased in nontaxable retirement accounts like Roth IRAs because you’ll never have to pay any income or capital gains taxes on your earnings when you cash out. Many companies offer TIPS in their 401(k) plans.

How to Invest in TIPS

The first thing to keep in mind when considering the pros and cons of investing in TIPS is simple to understand: TIPS won’t make you rich. Riskier stocks build wealth. TIPS can help maintain your money’s buying power in the face of rising inflation. This begs the question when inflation (CPI) currently is running under 2 percent: Do TIPS makes sense now for my portfolio?

If you’re young, inflation isn’t an immediate concern, but as you get closer to retirement and your time-horizon fades, investing in TIPS clearly makes more sense. Whether inflation is rising or falling, TIPS can typically be a modest component of any balanced portfolio (60 percent stocks and 40 percent bonds).

You can also buy individual bonds at TreasuryDirect, but it’s easier and smarter to invest in TIPS through mutual funds or exchange-traded funds (ETFs). One of the most popular funds for TIPS investing is the Vanguard Inflation-Protected Securities Fund (VIPSX), which has $28 billion in assets and an expense ratio of 0.20 percent. (That’s a fee of $2 on $1,000 invested.)