Do TIPS Actually Protect Against Inflation?July 26th, 2012 by David Waring
Treasury inflation protected securities (TIPS) are a type of US Government Bond that has a fixed coupon interest rate but whose principal, and therefore dollar amount of interest paid, adjusts based on the CPI-U. You can learn more about the mechanics of TIPS here.
Do TIPS Really Protect You Against Inflation?
If you buy TIPS when they are originally issued and hold them until maturity, then you will be protected against any rise in the CPI-U during the lifetime of the bond. There are several issues with this however that many investors in TIPS miss including:
- Your actual rate of inflation may differ from the CPI-U, as your spending habits may not mimic the rate of inflation on the basket of goods measured by the CPI-U. For example if your primary concern is being able to pay for your child’s education expenses, and inflation for tuition rises faster than the CPI-U, then you will not be fully protected.
- TIPS are not an inflation hedge which protects the entire value of your portfolio from inflation. When investing in TIPS you are only protected on the money in which you have invested in TIPS. If for example you have 5% of your portfolio invested in TIPS then only that 5% is protected.
Outside of these concerns however, yes TIPS which are bought at original issue and held to maturity do protect you against inflation. Where things get complicated is when you buy TIPS after they are issued in the secondary market and/or do not hold the TIPS to maturity.
The Yield on a TIPS is made up of two components:
TIPS Yield = Real yield + lagged actual inflation rate as measured by the CPI-U.
As you can see from the chart below, the real yield (the risk free rate minus inflation) changes over time.
The value of TIPS can fall and provide a return below inflation. This happens when you sell a TIPS before maturity when the real rate of return has increased. Just as with a normal bond, all else being equal, when the real yield goes up the value of the TIPS falls. This means that when the real yield is rising, the market value of the TIPS would be falling. This is true even if inflation was rising as well. This is a big issue with TIPS that are bought in the secondary market and/or not held until maturity. As they do not hold bonds until maturity, this is also a big issue with TIPS mutual funds and ETFs.
A Note on the Current Negative Real Return Situation
Going back throughout history real interest rates are almost always positive. Even when an investment is free from default risk, investors still require a return for tieing their money up (called a term premium, as an investor is potentially giving up better investment opportunities). As you can see from the chart above however, as a result of the ongoing global economic problems, real rates are currently negative. This means that after accounting for inflation you are currently guaranteed a negative rate of return when investing in TIPS.
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