Should You Buy Treasury Inflation-Protected Securities?

Treasury Inflation-Protected Securities (TIPS) are a type of U.S. Treasury bond specifically designed to protect investors from the eroding effects of inflation. These government-issued securities aim to preserve the purchasing power of an investment by adjusting their value based on changes in a recognized inflation index. Their structure offers a distinct approach to fixed-income investing compared to traditional bonds.

Core Mechanics of TIPS

TIPS possess a unique structure where their principal value is indexed to inflation, specifically the Consumer Price Index for All Urban Consumers (CPI-U). As inflation rises, the bond’s principal amount increases, and conversely, it decreases during periods of deflation. This adjustment occurs regularly, typically semi-annually, ensuring the bond’s value keeps pace with the cost of living.

Unlike conventional bonds, which pay interest on a fixed principal, TIPS pay a fixed interest rate (also known as the coupon rate) on their adjusted principal value. For example, if a TIPS has a 1% fixed interest rate and its principal increases due to inflation, the subsequent interest payments will be calculated on that higher principal, resulting in larger payments. This mechanism ensures that the interest income also maintains its purchasing power over time.

The concept of “real yield” is central to TIPS, representing the return an investor receives after accounting for inflation. When you purchase a TIPS, the fixed interest rate determined at auction is the real yield. This rate remains constant throughout the bond’s life, but the actual dollar amount of interest received fluctuates with the adjusted principal.

At maturity, investors receive either the inflation-adjusted principal or the original principal, whichever is greater. This provision protects the initial investment from being eroded by deflation, guaranteeing that the investor will receive at least their original par value back. This characteristic distinguishes TIPS from traditional bonds, which only return the nominal principal at maturity, regardless of changes in purchasing power.

TIPS and the Economic Environment

The behavior of TIPS is directly tied to inflation and interest rate movements. Rising inflation increases the principal value of TIPS, leading to higher interest payments and providing a defense against purchasing power loss.

Changes in real interest rates also influence the market price of TIPS. If real interest rates in the broader market increase after a TIPS is issued, the market value of existing TIPS with lower real yields may decline, as new issues become more attractive. Conversely, if real interest rates fall, existing TIPS may become more valuable.

While TIPS protect against inflation, their market price can still fluctuate before maturity due to changes in real interest rates. Selling a TIPS before its maturity date could result in a gain or loss, depending on prevailing market conditions, a characteristic shared with other bonds.

Tax Implications of TIPS

Understanding the tax treatment of TIPS is essential for investors, as both the interest payments and the principal adjustments are subject to federal income tax. The fixed interest payments received semi-annually are taxable as ordinary income in the year they are received. This is similar to the taxation of interest from other U.S. Treasury securities.

A unique aspect of TIPS taxation involves the annual principal adjustments. Even though the increased principal amount is not paid out to the investor until the bond matures or is sold, the annual increase in principal due to inflation is considered “phantom income” and is taxable in the year it occurs. This means investors may owe federal taxes on income they have not yet physically received.

For example, if a TIPS bond’s principal increases by $200 in a given year due to inflation, that $200 is taxable income for that year, even if the bond is held to maturity. This phantom income can be a significant consideration, especially for investors holding TIPS in taxable accounts. It requires careful tax planning to avoid unexpected tax liabilities.

While subject to federal income tax, income from TIPS, including both interest payments and principal adjustments, is exempt from state and local income taxes. This exemption can provide a tax advantage, particularly for residents in states with high income tax rates. Investors should consult tax professionals to understand the full implications for their individual circumstances.

Purchasing TIPS

TIPS can be acquired through two primary avenues: the primary market, directly from the U.S. Treasury, or the secondary market, via brokerage firms. Buying directly from the Treasury often involves participating in government auctions for new issues, while brokerage firms offer access to both new issues and existing TIPS.

Preparatory Information for TreasuryDirect

To purchase new issue TIPS directly from the U.S. Treasury, investors can use the TreasuryDirect website. Setting up an account requires specific personal information, including a Social Security Number or Taxpayer Identification Number, a U.S. bank account for payments and withdrawals, and a valid email address. This process establishes a secure online account from which Treasury securities can be managed.

Procedural Steps for TreasuryDirect

Once a TreasuryDirect account is established and linked to a bank account, investors can participate in TIPS auctions. The process involves logging into the account, navigating to the “BuyDirect” section, and selecting TIPS as the security type. Investors then choose the desired maturity (5, 10, or 30 years) and enter a non-competitive bid, which means they agree to accept the yield determined at the auction. Funds are typically debited from the linked bank account on the issue date of the security.

Purchasing through Brokerage Firms

Alternatively, TIPS can be purchased through brokerage firms, offering a convenient option for investors who already have existing investment accounts. Brokerage firms can facilitate the purchase of new issue TIPS at auction or allow investors to buy existing TIPS in the secondary market. The process generally involves placing a bond order through the brokerage account’s trading platform or with a financial advisor.