Treasury inflation-protected securities (TIPS): Rates, risks & how they work

Treasury inflation-protected securities (TIPS) can help protect your money from the inevitable: inflation. As one approach to inflation-protected investing, TIPS can help your portfolio keep pace as the costs of food, housing, college, health care and other needs go up.

TIPS work differently from traditional bonds because the principal adjusts with inflation, which can also change the interest payments you receive. Compared with another inflation-protected option, Series I savings bonds (or I bonds), TIPS offer some key differences in flexibility, purchase limits and how you invest. Here's what you need to know.

TIPS are U.S. government bonds designed to help protect your money’s purchasing power when prices rise. Unlike traditional bonds, TIPS are built to keep pace with inflation because their principal is tied to changes in the Consumer Price Index (CPI), which tracks changes in the prices consumers pay for goods and services.

As inflation rises, the principal value of your TIPS generally increases. And because TIPS pay a fixed interest rate on that adjusted principal, the interest payments you receive can increase, too. If prices fall, the principal can decrease along with your interest payments.

That doesn’t mean TIPS can’t lose value. Like other bonds, their market value can fall when interest rates rise, particularly if you sell before maturity. But when prices are climbing, TIPS can help safeguard your money from losing purchasing power.

TIPS have two moving parts: the principal and the interest you earn on it.

TIPS pay a fixed interest rate every six months. But because that rate is applied to an inflation-adjusted principal, the dollar amount you receive can change over time.

For example, say you have $10,000 in TIPS at a 2% fixed interest rate. If inflation brings the principal up to $10,400, you’ll still earn that same 2%, but it will now be applied to $10,400 instead of $10,000. So, as your principal rises with inflation, your interest payments can rise, too.

There’s also some protection built in. When an individual TIPS reaches maturity, you receive either its inflation-adjusted principal or its original principal, whichever is greater. So even if deflation has lowered the principal along the way, you won’t receive less than the original principal at maturity.

When you buy individual TIPS, you have a few maturity timelines to choose from: 5, 10 or 30 years. The interest rate is fixed when the TIPS is issued and stays the same for the life of the security.

Keep in mind, a fixed rate doesn’t mean a fixed interest payment. Because that rate is applied to your principal, which adjusts with inflation, the amount you receive can rise or fall over time.

There also isn’t one standard, fixed TIPS rate. New TIPS are sold through Treasury auctions, where rates and yields are determined based on current market conditions. If you’re shopping for individual TIPS, you can check current and upcoming Treasury auctions to see what’s available.

You may also see a TIPS interest rate and “real yield” listed separately. The interest rate determines the interest payments you receive, while the real yield reflects your return above inflation if you hold the security to maturity. Real yields and market prices can change after TIPS are issued, which is especially important to keep in mind if you plan to buy or sell on the secondary market.

If you want to invest in TIPS, you have basically three options:

• Buy individual TIPS
• Invest through TIPS mutual funds
• Invest through exchange-traded funds (ETFs)

The right route for you may depend on how much control you want and how hands-on you are with your investments. Here’s a deeper look at each option:

If you want to choose and manage your TIPS yourself, you can buy them directly through the U.S. Treasury at TreasuryDirect or through a bank or broker. The U.S. Treasury holds auctions for TIPS with 5-, 10- and 30-year maturities, and you also can buy and sell previously issued TIPS on the secondary market.

One advantage of going the individual route is the protection that comes with holding your TIPS to maturity. At that point, you'll receive either the security’s inflation-adjusted principal or original principal, whichever is greater.

If you prefer to leave the individual buying and selling decisions to someone else, a TIPS mutual fund gives you access to many TIPS at once, often holding dozens or hundreds of securities with different maturities.

That can give you diversified exposure to the TIPS market without having to select and manage each security yourself. But unlike an individual TIPS, a mutual fund doesn’t have its own maturity date. As TIPS within the fund mature, the fund can replace them with new securities. That means there’s no set date when you’re guaranteed to receive your original principal back.

TIPS exchange-traded funds (ETFs) offer another way to invest in a collection of TIPS through a single fund. Like other ETFs, TIPS ETFs trade throughout the day on an exchange, giving you an easy way to buy or sell your investment without managing the individual securities inside it.

As with a TIPS mutual fund, however, the value of an ETF can rise or fall with the market. And because the fund itself doesn't mature, you don't get the same principal protection you'd have by holding an individual TIPS to maturity.

TIPS can provide valuable inflation protection, but they don’t protect you from every type of investment risk. Before adding them to your portfolio, it helps to understand both sides.

1. Inflation protection. Interest payments and principal value are linked to inflation, which means that TIPS can perform better than other bonds during inflationary periods. When other bonds may be underperforming, TIPS can help keep pace with rising prices and add diversification to the fixed-income portion of your portfolio.
2. Low risk of default. Since TIPS are backed by the U.S. Treasury, the risk of default is extremely low.
3. Principal protection at maturity. Hold an individual TIPS to maturity, and you’ll receive either its inflation-adjusted principal or original principal, whichever is greater.

1. 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 on TIPS can adjust downward, reducing interest payments.
2. Interest rate risk. Like other bonds, the market value of TIPS can fall when interest rates rise. This risk can be especially important with TIPS mutual funds and ETFs, where you don’t control when the individual TIPS in the fund are bought or sold. Generally, the longer the duration, or maturity, of the fund, the greater the sensitivity to changes in interest rates. One way to mitigate this risk is to hold individual TIPS to maturity, when you’ll receive either the inflation-adjusted principal or the original principal, whichever is greater.

TIPS come with a tax consideration that’s worth knowing about upfront. The interest payments you receive every six months are subject to federal income tax, but not state or local income taxes.

There’s another piece that’s a little less obvious. If inflation increases the principal value of your TIPS, that increase generally is subject to federal income tax in the year it occurs, even though you haven’t received that money yet.

You’ll see the two types of income reported separately. Form 1099-INT reports the regular interest your TIPS pay, while Form 1099-OID reports increases in the inflation-adjusted principal. TIPS held in tax-deferred accounts such as IRAs do not receive annual tax reporting unless the account owner has taken a distribution from the IRA, in which case they would generally receive a 1099-R tax form.

Taxes can make the return on TIPS a little more complicated than it looks on paper. Before investing, consider talking with a tax professional or financial advisor about how TIPS could fit into your specific financial and tax situation.

If you’re considering TIPS, it can help to see how they stack up against I bonds. While both can help protect your money from inflation, TIPS differ in some important ways, including where you can buy them, how you can invest, purchase limits and how quickly they respond to changes in inflation.

These differences can make TIPS more flexible when you want to invest larger amounts, access your investment through a fund or buy and sell on the secondary market. And because TIPS principal adjusts with changes in the monthly CPI, they can respond more quickly to shifts in inflation than I bonds.

Treasury inflation-protected securities have received more attention as investors look for ways to protect their money from rising prices. While TIPS and other inflation-protected investments may 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 TIPS are a good fit for you.