What Is a TIPS Ladder and How Do You Build One?

A Treasury Inflation-Protected Securities (TIPS) ladder is an investment strategy combining inflation protection and a regular income stream. This approach involves purchasing multiple TIPS that mature at staggered intervals over several years. A TIPS ladder aims to offer predictable access to funds while safeguarding investment principal against rising prices. This article explains how this strategy works and its construction.

Understanding Treasury Inflation-Protected Securities (TIPS)

Treasury Inflation-Protected Securities (TIPS) are bonds issued by the U.S. Department of the Treasury. They are designed to shield investors from inflation, maintaining purchasing power. Unlike conventional Treasury bonds, a TIPS’ principal value adjusts based on changes in the Consumer Price Index for All Urban Consumers (CPI-U).

When inflation rises, the principal value increases; it decreases during deflation. The coupon rate for a TIPS is fixed at auction, but the dollar amount of interest payments fluctuates because it’s paid on the adjusted principal. For example, if a TIPS has a 1% coupon rate and its principal adjusts from $1,000 to $1,010 due to inflation, the semi-annual interest payment is calculated on the new $1,010 principal.

At maturity, investors receive either the inflation-adjusted principal or the original principal, whichever is greater, protecting the initial investment against deflation. A notable tax consideration is “phantom income,” where the annual principal increase due to inflation is taxable by the IRS in the year it occurs, even though the investor does not receive this cash until the bond matures or is sold. TIPS are generally exempt from state and local income taxes.

The Concept of Laddering Investments

Investment laddering divides a lump sum into several smaller investments, each with a different maturity date. This approach is commonly used with fixed-income securities like certificates of deposit (CDs) or bonds. The primary purpose is to manage interest rate risk, avoiding the need to invest all capital at a single interest rate.

By staggering maturities, an investor ensures a portion of their portfolio matures regularly, providing periodic access to funds. As each rung matures, proceeds can be reinvested into a new long-term security at prevailing interest rates. This systematic reinvestment smooths income streams and provides liquidity at predictable intervals. The technique offers flexibility, allowing investors to capture higher rates if interest rates rise, while still benefiting from earlier investments if rates fall.

Combining TIPS and Laddering: The TIPS Ladder

A TIPS ladder integrates the inflation-protective features of TIPS with the staggered maturity benefits of laddering. This involves purchasing multiple TIPS with varying maturity dates, such as 5-year, 10-year, and 30-year terms. The goal is to create a portfolio offering continuous inflation protection and regular access to maturing principal.

This combined approach directly addresses inflation risk, as the principal value of each TIPS adjusts with the Consumer Price Index. The laddering aspect ensures a segment of the investment matures periodically, providing liquidity for reinvestment into new TIPS or other financial needs. While the coupon rate is fixed, the dollar amount of interest payments increases with inflation, providing a rising income stream that helps maintain purchasing power.

The TIPS ladder works by having bonds mature at regular intervals, perhaps annually or every few years. As a TIPS matures, the inflation-adjusted principal can be reinvested into a new long-term TIPS, extending the ladder. This continuous reinvestment helps perpetually hedge against inflation, providing a stable real return over time. The strategy balances long-term inflation protection with periodic access to capital.

Constructing a TIPS Ladder

Building a TIPS ladder begins with where to purchase these securities. Individual investors can buy TIPS directly from the U.S. Treasury through the TreasuryDirect website, often in increments as low as $100. Alternatively, TIPS can be purchased through brokerage accounts, though some brokers may have higher minimum investment requirements, such as $1,000 for individual bonds.

The next step is to choose appropriate maturity dates to create the staggered ladder. Common maturities for TIPS are 5-year, 10-year, and 30-year terms, allowing flexibility in ladder design. For instance, an investor might purchase TIPS maturing in 5, 10, 15, and 20 years to create a well-distributed ladder. This selection should align with financial goals and anticipated liquidity needs.

Determining the investment amount for each rung depends on total capital and desired income or liquidity. Investors typically allocate equal amounts to each maturity date to maintain balance. Once a TIPS matures, the inflation-adjusted principal is returned. This capital can then be reinvested into a new long-term TIPS at the longest end of the ladder, maintaining the strategy’s structure and benefits.