One downside of many low-risk investment products is that the rate of the return often does not keep pace with inflation. That downside is eliminated with Treasury Inflation Protected Securities (TIPS). With TIPS, your investment principal increases alongside the Consumer Price Index (CPI). TIPS make it possible to invest with low risk without worrying about inflation erasing most or all of your return.What are Treasury Inflation Protected Securities?
Treasury inflation protected securities (TIPS) are a type of fixed-income security that the United States Treasury issues on a regular basis. Fixed income investments are investment products that are typically low-risk and pay out interest at fixed amounts until their maturity.
TIPS are very similar to a conventional Treasury bond, but there’s one key difference. While a standard treasury bond will keep the same principal throughout its term, the par value of a TIPS will increase in line with the Consumer Price Index (CPI). This is intended to keep the principal of the bond on track with inflation.
In other words, if inflation occurs in a given year, your investment will increase in value during that year. So, instead of having a bond that’s worth relatively less once it matures, you have a bond that maintains its value throughout its life.How TIPS work
TIPS typically come in 5-, 10- or 30-year terms. Just like conventional treasury bonds, you will receive interest payments twice a year. To purchase TIPS, you have several options. You can purchase newly issued TIPS directly from the U.S. Treasury if you have a TreasuryDirect account. This is typically the cheapest option. If you’d rather not go through the process yourself, you can also purchase TIPS from a bank or investment broker.
To break down how a treasury inflation protected security works, let’s consider an example. Let’s say you purchase a TIPS with a par value of $1,000 and an interest rate of 0.3%. After one year, the Consumer Price Index has risen 4%, which means the par value of your bond is now $1,040. So instead of receiving $3 in interest, your investment has risen a total of $43.12.Pros and Cons of TIPS
The most obvious pro of TIPS is inflation protection. Because each security is tied to the CPI, you can rest assured that inflation won’t undercut its value. All this adds up to about as low-risk an investment as you can imagine.
As we know, however, limited risk usually means limited reward. The biggest downside of TIPS is that, because they’re protected against inflation, the interest rates are typically very low, almost always below 1.0%. So, while they’re great for protecting wealth you already have, no one is going to make their nest egg by investing in TIPS.
Another downside of TIPS is that, just as a rise in the CPI will increase the value of your bond, a decrease will also lower the value. This means that your investment could lose value during periods of deflation, the opposite of inflation. Luckily, deflation is much less common than inflation in the U.S. economy. Further, the Treasury Department has said that it would pay owners of TIPS full value if a period of deflation were to occur.TIPS vs. Other Fixed Income Securities
The biggest difference between TIPS and other fixed income products (for instance, treasury bills and corporate bonds) is the protection against inflation that TIPS provides. Rather than guaranteeing an increased par value, many traditional fixed income investments use expected inflation to influence the offered interest rate. In other words, if bond issuers expect a lot of inflation in the future, they may offer a higher interest rate than they otherwise would have in order to keep the bond attractive to purchasers. If inflation then turns out to be lower, purchasers of that bond enjoy a larger real interest rate (interest rate minus inflation rate).
So in terms of the real return you can expect, TIPS offer a higher floor and lower ceiling. On the other hand, many other more conventional bonds offer a lower floor but a higher ceiling. This is intuitive, as TIPS are an extremely low-risk investment, even in the realm of fixed income.Bottom Line
If you are looking for low-risk options to balance out your investment portfolio, treasury inflation protected securities are a great option. These investments aren’t without their downsides. However, they can serve as an excellent hedge against riskier investments without losing any value to inflation.Tips for Smart Investing
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