Education

Understanding Treasury Inflation‑Protected Securities (TIPS)

Learn how TIPS guard against inflation and the benefits of adding them to your portfolio.

For many investors, inflation-protected bonds – specifically designed to protect against rising consumer prices – are an effective way to guard against inflation. And Treasury Inflation-Protected Securities, known as TIPS, are one of the most attractive members of this asset class.

What is inflation and why should I be concerned about it?
Inflation is an increase in the price of goods and services. In the U.S., a widely accepted measurement is the Consumer Price Index (CPI). As the chart below shows, prices have risen steadily in the U.S. since the end of World War II.

In effect, inflation shrinks the value of your money. The dollar you invest today will be worth less tomorrow, posing a serious threat to investors. And for bondholders, it is a particular concern, since it can erode the purchasing power of future interest and principal payments.

How do TIPS work?
Treasury Inflation-Protected Securities, or TIPS, are inflation-protected bonds (IPBs) that are issued by the U.S. Treasury. Their face value is adjusted in step with changes in the rate of inflation. The Treasury then pays interest on the adjusted face value of the bond, creating a gradually rising stream of interest payments as long as inflation continues to rise. At maturity, a TIPS investor will receive the original face value plus the sum of all the inflation adjustments since the bond was issued.

It works like this: Suppose you invest $1,000 in a new 10-year TIPS with a 2% coupon rate. If inflation is 3% over the next year, the face value will be changed to $1,030 and the annual interest payment would be $20.60, or 2% (the coupon rate) of the adjusted principal and so on. In a deflationary environment, the reverse would be true: the face value and interest payments would decrease, but still keep pace with the now lower cost of goods and services.

As a result, TIPS and other IPBs offer a “real” rate of return – the actual return of an investment after inflation is taken into account. A traditional bond, on the other hand, offers a “nominal” return. It maintains a fixed face value until maturity, with no adjustments for inflation. For example, if you’re receiving a 5% return on a traditional bond and inflation is rising at 3%, your “real” return is actually only 2%.

The rising cost of a dollar

What are some other advantages of investing in TIPS?

  • TIPS can potentially be an effective portfolio diversification tool. Because TIPS have a low correlation with other types of investments, they may reduce overall portfolio volatility.
  • TIPS offer the government’s assurance that investors will never receive less than the original face value of the bond at maturity, even in the event of deflation during the life of the bond (when prices actually fall).

How does the risk on TIPS compare with other bond investments?
TIPS do not carry credit risk thanks to their government guarantee. However, like all bonds, TIPS are subject to interest rate risk. TIPS should perform better in a rising interest rate environment than conventional Treasury bonds because their inflation adjustments provide better price protection, but that is only when rates are rising as a result of increasing inflation. If rates were to rise in an environment of low or no inflation, TIPS’ prices could decline.

Investors who purchase individual TIPS should be aware of a phenomenon called “phantom income.” This means that the TIPS inflation adjustment is taxable in the year it occurs even though you won’t receive this money until the bond matures. This differs from a mutual fund, however, because a fund pays out both interest income and the income from principal adjustments to investors monthly. You pay the federal income tax, of course, but you’re also receiving the income you’re paying it on.

Investors who own TIPS through a mutual fund should also be aware that the fund may perform differently than the underlying bonds. Individual TIPS guarantee an inflation-adjusted return if held to maturity, but there is no guarantee for a fund that invests in them. A portfolio manager may buy or sell TIPS before maturity, which could lead to gains or losses.

How can I invest in TIPS?
You can purchase TIPS directly from the U.S. Treasury for a minimum purchase amount of $1,000. You may also choose a mutual fund or exchange-traded fund that invests in TIPS, which offers the additional benefits of professional management. Your investment professional can help you decide whether such an investment is right for you.

How TIPS can grow in value

Disclosures

A word about risk: Diversification does not ensure against loss. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value.

The Consumer Price Index (CPI) is an unmanaged index representing the rate of inflation in U.S. consumer prices as determined by the U.S. Bureau of Labor Statistics. There can be no guarantee that the CPI or other indexes will reflect the exact level of inflation at any given time. It is not possible to invest directly in an unmanaged index.

This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. PIMCO Investments LLC, distributor, 1633 Broadway, New York, NY 10019, is a company of PIMCO. © 2016 PIMCO