Tips Funds: A Guide To Smart Investing

Treasury Inflation-Protected Securities (TIPS) are government-issued bonds that protect investors from inflation. TIPS are indexed to inflation, meaning that when inflation rises, the face value of the bond increases to maintain its real value. This makes TIPS popular with investors, especially during periods of high inflation or poor economic performance.

TIPS can be purchased directly from the US government through the TreasuryDirect system, or via a brokerage firm. They can also be bought indirectly through a TIPS mutual fund or exchange-traded fund (ETF).

TIPS vs. Series I Bonds

TIPS (Treasury Inflation-Protected Securities) and Series I Bonds are both government-issued inflation-indexed bonds. They are designed to protect investors from inflation by adjusting the principal and interest payments based on consumer price index changes. However, there are several differences between the two:

Resale

TIPS can be resold on the secondary market, whereas I-Bonds cannot. This gives TIPS an advantage in terms of flexibility, as investors can sell them before maturity if needed.

Maturity

TIPS are issued in three different maturities: 5, 10, and 30 years. On the other hand, I-Bonds are sold in 30-year terms only. This means that investors in I-Bonds are committed to a longer investment period.

Purchase Limits

There is no practical limit to the number of TIPS that can be purchased. In contrast, I-Bonds have an annual limit of $15,000 total, which includes $10,000 in electronic bonds and $5,000 in paper bonds. This makes TIPS more attractive to investors who want to invest larger sums of money.

Inflation Adjustments

Both TIPS and I-Bonds adjust their principal and interest payments based on inflation. However, they differ in the frequency of these adjustments. TIPS are adjusted for inflation every day, while I-Bonds are adjusted every six months. This makes TIPS more responsive to inflationary changes.

Interest Accrual and Payments

TIPS pay out interest every six months, while interest on I-Bonds is accrued until the bonds are redeemed. Whether this is an advantage depends on the investor's need for regular interest payments. Additionally, interest payments and inflation adjustments on TIPS are taxable every year, while taxes on I-Bonds can be deferred until redemption or maturity.

Pricing Transparency

The prices and yields of TIPS are set by the market, while the fixed rates of I-Bonds are set by the U.S. Treasury. This gives the U.S. Treasury an incentive to set lower fixed rates on I-Bonds, which may result in lower yields for investors.

Fees

There are generally no fees for purchasing I-Bonds, while TIPS purchased through a mutual fund may incur management fees. This is a cost consideration for investors when deciding between the two options.

Negative Real Rates

In periods of negative real interest rates, the fixed rate on TIPS can also be negative. However, the fixed rate on I-Bonds has a floor of 0% and cannot go negative, giving I-Bonds an advantage in such scenarios.

In summary, TIPS offer more flexibility and responsiveness to inflationary changes, while I-Bonds provide certain advantages such as the ability to defer taxes and protection against negative real interest rates. The choice between the two depends on the investor's specific needs, risk tolerance, and investment goals.

Pros and Cons of Investing in TIPS

Treasury Inflation-Protected Securities (TIPS) are government-issued bonds indexed to inflation. When inflation rises, TIPS can generate greater returns compared to bonds that are not inflation-linked.

Pros

• Inflation protection: TIPS provide protection from inflation by adjusting the principal relative to the CPI-U.
• Principal protection: At maturity, you get back at least the original principal.
• Regular interest: TIPS pay interest every six months, so you can count on regular income from these securities.
• Relative safety: As US government-backed securities, TIPS are among the safest investment options.

Cons

• Lower interest rate: TIPS often pay lower interest rates than other Treasury securities.
• Potential loss: You are guaranteed the return of your principal only if you hold the TIPS to maturity. If you sell before then on the secondary market, you could receive less.
• Reduced interest due to deflation: Since the principal is reduced during periods of deflation, you may receive lower interest payments when inflation declines.
• Interest rate risk: Interest rate increases can cause the value of TIPS to decline.
• Underperformance: TIPS tend to underperform traditional treasuries and stocks in the long run.

TIPS in Today's Market Climate

Treasury Inflation-Protected Securities (TIPS) are a type of government-issued bond that can protect investors from inflation. When inflation rises, the face value of TIPS increases to maintain their real value, making them popular with investors. However, in today's market climate, there are some important considerations regarding TIPS.

Firstly, TIPS have advantages over other types of bonds when it comes to inflation protection. The principal value of TIPS rises with inflation, and investors receive larger interest payments during inflationary periods. This feature can be particularly attractive to retirees or those seeking a stable income stream.

However, TIPS also have some drawbacks. They often provide lower interest rates than other Treasury securities, and they tend to underperform stocks in the long run. As such, TIPS are generally considered a wealth protection tool rather than a wealth-building instrument. Additionally, TIPS can be more volatile than cash, especially during stock market crashes.

Another factor to consider is the current interest rate environment. As of March 2024, interest rates were high, and the Federal Reserve was focused on lowering inflation. In such an environment, TIPS may not be the best investment choice, as their value can be negatively impacted by rising interest rates.

Furthermore, TIPS may not be the best option for investors seeking to reduce volatility in their portfolios. Due to the fluctuating nature of their principal, TIPS can be more sensitive to interest rate changes than other fixed-income securities.

Therefore, while TIPS can provide a valuable hedge against inflation, they should be approached with caution. Investors should carefully consider their investment goals and the current market conditions before deciding whether to invest in TIPS.

Ways to Further Lower Risk With TIPS

There are several ways to further lower the risk when investing in TIPS (Treasury Inflation-Protected Securities).

Firstly, investors might consider holding bonds until maturity. This ensures that a bond investor will receive the full principal value adjusted for inflation, minimising the loss of purchasing power. By holding bonds until maturity, investors are guaranteed to receive at least their original investment back.

Another strategy is to build a TIPS ladder. Instead of putting everything into a single issue, investors can stagger maturities over time. This smooths out interest rate sensitivity and ensures that some TIPS are coming due soon.

TIPS are considered a relatively safe investment option as they are backed by the full faith and credit of the US government. They are, however, not risk-free. For example, TIPS are considerably more volatile than cash, especially during stock market crashes.

TIPS also frequently underperform traditional US Treasury bonds, particularly when inflation is low. This is because TIPS rely on the Consumer Price Index (CPI), which may understate inflation for TIPS investors as they tend to be older and less likely to switch to new goods.

TIPS are also subject to interest rate risk. Interest rate increases can cause the value of TIPS to decline.

Direct Ownership of TIPS vs. TIPS ETFs

Buying and Selling

TIPS funds can be bought and sold at any time, like stocks, through brokerage accounts. Individual TIPS, on the other hand, must be purchased at auctions held at specific intervals throughout the year.

Liquidity

TIPS ETFs are highly liquid and can be traded throughout the day on stock exchanges. In contrast, individual TIPS are less liquid and can be challenging to sell quickly at market value.

Minimum Investment

TIPS ETFs have a lower minimum investment, depending on the price of a single ETF share. If fractional shares are allowed, the minimum investment could be even lower. Individual TIPS typically have a higher minimum investment, usually $100 for new issues.

Diversification

TIPS ETFs offer instant diversification across a range of TIPS maturities, while purchasing a single TIPS provides no diversification.

Dividends and Interest Payments

TIPS ETFs typically distribute dividends (interest payments and capital gains) more frequently, often on a monthly basis. In contrast, individual TIPS pay interest semi-annually.

Management Fees

TIPS ETFs incur management fees or expense ratios, whereas individual TIPS have no ongoing management fees.

Market Price

The market price of TIPS ETFs can be above or below the TIPS' net asset value (NAV). Individual TIPS are priced at par value at auction, but their market price can vary afterward.

Taxation

Interest and capital gains from TIPS ETFs are taxable. Individual TIPS are often exempt from state and local taxes, but federal taxes apply.

Professional Management

TIPS ETFs are professionally managed by the ETF provider. Individual TIPS are self-managed unless held in a managed account.

Frequently asked questions