Many portfolio strategists recommend that retirees allocate 5-10% and some financial advisors even recommend up to 20-40% of their fixed-income portfolio to TIPS (Treasury Inflation-Protected Securities). Given record budget deficits and massive government spending, it is not unreasonable to expect inflation at some point. While inflation over the past 10 years has averaged only 2.5 – 3.0%, recently the trend has seen a sharp rise in the price of basic commodities. Many investors soured by the 2008 market decline have become more cautious, especially those nearing retirement, who are looking for both safety and a hedge against the inflation. So, what are TIPS, why would you want them in your portfolio, and what are the alternatives?

What are TIPS and How Do They Work?

TIPS are inflation-indexed bonds with 5, 10, and 30-year maturities, issued by the U.S. Treasury, with the full backing of the U.S. government. The principal amount is adjusted twice a year based on the CPI-U Consumer Price Index for Urban Consumers a common measure of inflation. The coupon rate, or the interest you earn, is fixed. However, the interest payment you receive semiannually fluctuates because the principal amount to which it is applied is adjusted up for inflation and down for deflation. Paying the coupon rate on a higher principal amount raises the effective yield of the security  A reduced principal amount would reduce the effective yield. At maturity you are paid the greater of your original principal or the adjusted principal.

Interpreting the TIPS Yield

The yield gap between 10-year TIPS and the 10-year Treasury Note is called the break-even rate and implies an expected annualized inflation rate.

For example, if the yield for 10-year TIPS is 1%, and the yield for the 10-year Treasury Note is 3%, the 10-year TIPS will outperform the Treasury Note if inflation averages more than 2% over the 10-year period. The lower the break-even rate, the easier it is for TIPS to outperform standard Treasury securities. Thus, active investors would want to consider adding TIPS to their portfolios when they think that inflation will be higher over the next several years than what is currently priced into the inflation breakeven rate. The same analysis can be done for 5-year TIPS and 5-year Treasury Notes.

Why TIPS?

1. Unlike traditional (nominal) bonds that have fixed semi-annual payments for as long as you own the bonds, TIPS protect your principal against inflation. Buying TIPS is an offensive move against rising prices and a defensive move against deflation since TIPS are guaranteed to pay at least their original principal amount at maturity.

Paychecks generally keep up with rising prices over the long run, on average but retirees with a portfolio largely allocated to fixed income investments must primarily depend on inflation-adjusted Social Security benefits. TIPS provide another strategy for coping with inflation.

2. TIPS have historically had a low correlation with other asset classes. Since they don’t behave like most other bonds or stocks under similar market conditions TIPS add diversification to your total portfolio.

But, using TIPS for your entire fixed income allocation would means no corporate bonds, no asset-backed bonds, nor any other type of bond that outperforms a Treasury or other government-backed bonds at various points in time.

3. TIPS have a zero-risk of negative real return the total return less the inflation rate, although the real return could be zero only keep up with inflation as measured by the CPI-U.

4. A robust secondary market, as well as TIPS mutual funds and ETFs, means TIPS are very liquid or easily converted to cash.

5. TIPS provide regular income in the form of semiannual interest payments.

Why Not TIPS?

1. TIPS protect you from an increase in the CPI-U, but do not necessarily protect you from an increase in nominal (coupon) yields.

If the yield-to-maturity for a regular Treasury security is 3% and 1% for TIPS with the same maturity, the yield difference is the breakeven inflation rate. The market expects a 2% inflation rate. If actual inflation exceeds 2%, holding TIPS is the better option. Choosing TIPS when the breakeven inflation rate is 2% means you expect inflation to exceed 2%, over the life of the TIPS.

However, if over time, nominal (coupon) yields rise, say from 3% to 4%,  and the inflation expectation remains stable at 2%, the market value for these TIPS would fall just like any nominal bond would react. Conversely, if the nominal (coupon) yield remains 3% and inflation expectation grows to exceed 2%, the market value for TIPS would increase.

2. It would take an inflation spike to put TIPS in the top of the performance chart. Other investments will most likely provide higher yields over the long run, but not the protection TIPS afford if inflation suddenly surges.

3. TIPS are not tax efficient. Both the inflation adjustment to principal (“phantom income”) and the interest payments are taxed as ordinary income for federal income tax purposes.  But like Treasury securities, TIPS are tax exempt from state and local income tax. “Phantom income” means that you must pay income tax on the increase in the value of your investment without the benefit of an accompanying cash payment to you for the amount of that taxable income. “Phantom income” is the reason most financial advisors recommend that TIPS be held in a tax deferred account such as a  401(k) or traditional IRA account   or a tax free account such as a Roth IRA.

If you were to hold TIPS through a mutual fund or ETF in a taxable account, you will receive a 1099-INT from the fund for reporting your taxable income. Most TIPS shareholders reinvest their fund distributions because if the inflation adjustment is not reinvested your TIPS fund holding will not effectively offset the effects of inflation. If you must hold TIPS in a taxable account, you should consider I Savings Bonds.

4. TIPS generally return less than traditional Treasury bonds with similar terms.

5. TIPS funds may be volatile. They are priced on a daily basis based on expectations of future inflation rates, and the current market value is also affected by changes in interest rates.

What, Why, and Why Not TIPS?

Next we look at  TIPS: How, Where, When, and What Else? where to buy TIPS, when should you buy them, and what are other investment options for insuring fixed income against an erosion in purchasing power due to inflation.