What are inflation-protected bonds?

With inflation at 40-year highs, you may be wondering what steps you can take to help protect your finances and secure the foundation you've built. When it comes to investing for inflation, some investment securities tend to perform better than others, and diversification is important. That's where inflation-protected bonds, such as Treasury inflation-protected securities (TIPS), can help to hedge against inflation.

Inflation-protected bonds are a type of investment security that can provide a hedge against rising prices for goods and services. These bonds work as an inflation hedge because they receive positive inflation-related adjustments during inflationary periods. During times of higher inflation, inflation-protected bonds may perform better than other more standard bond types.

The U.S. Treasury issues inflation-protected bonds to help reduce the risk of inflation for bond investors. With these types of bonds, interest payments and principal values adjust upward with rising inflation—and interest and principal decline in value with deflation. Other types of bonds, contrastingly, are often negatively impacted by inflation because it lessens the value of their fixed interest payments. For example, if you own a bond that yields 3% but inflation is 4%, your real yield (after inflation) is a 1% loss.

High inflation not only reduces the real yield on most bonds, but it also can push down their prices. The reason for this is that the Federal Reserve raises interest rates to fight inflation. Since bond prices generally move in the opposite direction of interest rates, a high-inflation, rising-rate environment not only will make your interest payments less valuable, but the price of most bonds will go down as well.

The upshot: Including inflation-protected bonds can help bring balance to your portfolio in times of high inflation. While your other bonds may be underperforming, your inflation-protected bonds can keep pace.

Inflation-protected bonds are indexed, or linked, to an inflation index, such as the Consumer Price Index (CPI). This is a weighted average of the change in price for a fixed basket of goods and services commonly purchased by U.S. consumers—including everything from rent and household furnishings to transportation and medical care services. Interest payments on inflation-protected bonds increase with inflation and decrease during deflation. Put simply, inflation-protected bonds move up and down with inflation as measured by the CPI.

There are two types of inflation-protected bonds: TIPS and Series I savings bonds (also called I bonds).

Treasury inflation-protected securities (TIPS) are bonds designed to adjust up or down with inflation. A TIPS bond principal is adjusted by changes in the CPI. When inflation rises, the index rises, as does the principal on the TIPS. If inflation occurs, the interest payment also increases. In the event of deflation, the TIPS interest payment decreases.

There are three main ways to invest in TIPS:

• Individual TIPS. Investors can buy TIPS through TreasuryDirect, a website sponsored by the U.S. Treasury, or through a bank or broker. Auctions are periodically held throughout the year by the U.S. government, and TIPS are available in five-, 10- and 30-year maturities. Investors also can buy or sell individual TIPS in the secondary market like other investments.

• TIPS mutual funds. Many investors buy TIPS through mutual funds, which generally hold dozens or hundreds of TIPS of various maturities. By holding a mutual fund, an investor can conveniently gain diversified and indirect access to the TIPS market.

• TIPS ETFs: Exchange-traded funds (ETFs) are similar to mutual funds in that an investor can gain indirect access to the TIPS market with just one fund.

Series I savings bonds, or I bonds, are a type of inflation-protected bond that adjusts its interest payments twice per year based on inflation. Since the interest rate for I bonds is set semiannually, bondholders receive the current rate until the end of the six-month period, when a new rate is set. Investors only can get I bonds through TreasuryDirect and are limited to purchasing up to $10,000 of them per year.

While TIPS and I bonds are both types of inflation-protected bonds, they also have some significant differences, including where to buy them, purchase limits and how they are linked to inflation.

The primary differences between TIPS vs. I bonds are:

• Where you can buy them. Both TIPS and I bonds can be purchased through TreasuryDirect online. TIPS also can be bought and sold on the secondary market through a bank or broker, but I bonds only can be bought through TreasuryDirect.

• How to invest in them. TIPS can be purchased as individual bonds or through mutual funds or ETFs. I bonds only can be purchased as individual bonds with an annual total purchase limit of $10,000.

• Inflation indexing. TIPS adjust up or down with the monthly CPI report on inflation or deflation, but I bonds are linked to inflation and set semiannually in May and November.

Although TIPS provide inflation protection, there are some risks involved that could cause a loss of principal, and they do not protect investors from all types of risk.

• Inflation protection. Interest payments and principal value are linked to inflation, which means that TIPS can perform better than other bonds during inflationary environments.

• Low risk of default. Since TIPS are backed by the U.S. Treasury, the risk of default is extremely low.

• Deflation risk. TIPS can perform well during inflation, but when there is deflation, or a general decline in the prices of goods and services, the principal and interest rates on TIPS adjust downward.

• Interest rate risk. Like other bonds, the principal value of TIPS can fall when interest rates are rising. This risk is primarily associated with TIPS mutual funds and TIPS ETFs, where the investor does not control the buying or selling of TIPS within the fund. One way to mitigate this risk is by holding individual TIPS yourself and not selling them until their maturity, when you can receive either the adjusted principal or the original principal back, whichever is greater.

The semiannual interest payments from TIPS are taxed as income at the federal level but not at the state or local levels. If you have an increase in the value of the TIPS principal, you also are subject to federal tax the year that the increase occurs. Interest is reported to you on Form 1099-INT, and increases in principal are reported on Form 1099-OID.

TIPS are relatively easy investment types to understand, but the taxation of these inflation-protected bonds is not always simple. As with other investment types, investors are wise to consult a tax professional or financial advisor about their specific financial situation before making any investment decisions with potential tax consequences.

Treasury inflation-protected bonds are a lesser-known investment type that have received much more attention now that inflation has reached 40-year highs. While TIPS and other inflation-protected bonds sound like a good idea, learning how to invest during inflation means identifying the specific strategies that work for you.

As you begin planning an investment strategy for inflation, consider reviewing your portfolio and working with a local Thrivent financial advisor to confirm whether or not inflation-protected bonds are a good fit for you.