If you will soon be taking income from your portfolio, you are understandably concerned about the risk of future inflation. One available tool to counter that risk is Treasury Inflation Protected Securities (TIPS), an inflation-indexed bond offered by the U.S. Treasury. No other U.S. government security offers the same advantage as TIPS. Their principal value increases without limit every six months in line with changes in the Consumer Price Index (CPI). The bond’s coupon rate of interest doesn’t change, but as the principal grows it causes the amount of interest paid to the investor to increase. When the security matures, the U.S. Treasury pays the original or adjusted principal, whichever is greater.
There are a few advantages to TIPS. First, TIPS have almost no risk of default (credit risk), and investors receive unlimited protection against the loss of value caused by inflation. They can be a useful diversification tool to balance portfolio risks. While short-term cash equivalent investments such as money market funds and Treasury bills also have a low risk of principal loss, the downside is that inflation can erode their real value. Because bond yields generally exceed cash equivalent yields, a portfolio that uses TIPS to balance the market risk of equities may achieve higher returns.
TIPS also have a few minuses. They do not escape general bond market risk. Also, their principal will be reduced if the CPI declines in the future, although it will not drop below the bond’s face value. In a deflationary environment, TIPS are not as beneficial as a bond that is not indexed to inflation. Lastly, the semiannual inflation adjustments of TIPS are considered taxable income by the IRS even though investors don’t see that money until they sell the bond or it reaches maturity.
TIPS are a complicated investment to understand, but they can be a useful tool to help protect you from rising inflation.
