For bondholders who are concerned about current or future inflation eroding the value of their bonds, Treasury Inflation-Protected Securities (TIPS) are an alternative worth looking at. TIPS are Treasury bonds that are guaranteed to keep pace with inflation, as defined by the Consumer Price Index (CPI).
How do TIPS work?
The interest payments from TIPS are continually updated based on the CPI inflation rate. As an example, consider a $1,000 inflation-protected bond with a 1% real interest rate, purchased on January 1. If inflation was 1% during the first six months of the year, the value of the security would be inflation-adjusted to $1,010 ($1,000 x 1.01).
In the middle of the year, the bondholder would receive $5.05 ($1,010 x 1% divided by 2).
If inflation increased to 3% during the second half of the year, the bond value would be $1,030 ($1,000 x 1.03). The second semiannual payment would be $5.15 ($1,030 time 1% divided by 2). Therefore, both the bond’s value and interest payments are protected against inflation.
TIPS are more popular when inflation is high, as more bondholders become concerned about the value of their bonds being eaten away. Likewise, when inflation is low, or in deflationary times, regular bonds become more attractive relative to TIPS because future interest payments are more valuable on an inflation-adjusted basis.
How do you buy TIPS?
TIPS can be purchased the same as any other type of Treasury bond, either directly from the U.S. Treasury or a broker. There are also mutual funds that specialize in inflation-protected bonds. Buying from the Treasury is the lowest cost option, but mutual funds give you access to a diversified portfolio of TIPS.
Many people use bonds as a way to diversify their investments. Stocks historically give higher returns, but are more volatile than bonds. Therefore having a portion of your investments in bonds can reduce overall volatility of your investments. Using TIPS provides even more stability as it removes uncertainty due to inflation.
Some people even try to time their purchases of bonds, buying TIPS when inflation is expected to be high and regular Treasury bonds when it is expected to be low or negative. However market timing is neither easy nor always successful, and transaction costs can lower returns.
For additional information
For more information about inflation-protected bonds, see this article.