TIPS and Inflation: What to Know Now

Worried about inflation? Treasury Inflation-Protected Securities, or TIPS, can help protect against inflation since their principal values are indexed to the Consumer Price Index (CPI). When considering TIPS, however, it's important to understand their unique characteristics and complex nature.

TIPS are a type of Treasury security whose principal value is indexed to inflation. When inflation rises, the TIPS' principal value is adjusted up. If there's deflation, then the principal value is adjusted lower. Like traditional Treasuries, TIPS are backed by the full faith and credit of the U.S. government.

The coupon payments are based on a percent of the adjusted principal, so investors can benefit from higher income payments when inflation is rising, as well.

At maturity, however, a TIPS investor would receive either the adjusted principal or the original principal value at issuance. In other words, TIPS never pay back less than their initial principal value at maturity, barring default.

The table below illustrates how the principal value and coupon payments would rise if inflation averaged 3% every year for a hypothetical five-year TIPS. While the initial principal value is $1,000, after one year that principal value would grow to $1,030. The investor would still earn a coupon payment based on the 2.125% coupon rate, but since the principal value would have risen, the coupon payment would be $21.89 at the end of year one. By maturity, the principal value would rise to $1,159 if inflation continued to average 3% per year.

Here are three considerations for those considering TIPS today:

1.  Relatively high yields. Like most bond yields, TIPS yields have risen sharply over the last few years and are still near the high end of their 20-year range. More importantly, TIPS yields are positive, meaning investors who hold individual TIPS can earn a positive inflation-adjusted yield regardless of the inflation rate.

TIPS yields are "real" yields, already accounting for inflation. The annual rate of inflation over the life of a TIPS ultimately would be added to the stated yield when held to maturity to come up with the annualized return. If inflation averages 3% for the next five years, for example, that 3% inflation rate would get added to the roughly 2.1% "real" yield that a five-year TIPS offers today, resulting in a nominal return of 5.1% annually. The higher (or lower) inflation comes in, the higher (or lower) that nominal total return would be.

Here's another way to think about TIPS yields: If held to maturity, TIPS should outperform inflation on an annualized basis by a magnitude of that yield. That can be an important concept for investors who are worried that inflation will remain very elevated for a while.

"Real" yields have generally risen lately as the Fed tries to cool inflation. High real interest rates make it more attractive for consumers to save than spend, and more difficult for businesses to borrow, hire, and invest. But high real yields can present investors an opportunity to beat inflation going forward.

2.  Breakeven rates. The difference between TIPS yields and yields offered by traditional Treasuries is important to consider when evaluating TIPS. That difference is known as the "breakeven inflation rate." It's the rate that inflation, as measured by the Consumer Price Index (CPI), would need to average over the life of the TIPS for it to outperform a traditional Treasury security. If the CPI averaged more than that breakeven rate, investors would have been better off in a TIPS; if it were below, a traditional Treasury would have made more sense.

The five-year breakeven rate is shown in the chart below. At 2.3%, inflation would need to average 2.3% or more over the next five years for a five-year TIPS to outperform a nominal Treasury. That's still below the current rate of inflation, and the recent disinflationary trend in the headline CPI appears to have stalled as the year/year change in headline CPI has fluctuated in the 3.1% and 4% area over the last 12 months. Although the 2.3% breakeven rate is at the high end of the 14-year range, it's below the current inflation rate by a relatively large margin.

3.  Principal values have adjusted higher, despite negative total returns. TIPS total returns—when measured by TIPS indexes—generally have been negative over the last few years, despite multi-decade high levels of inflation.

TIPS, despite their unique characteristics, are still bonds and subject to the inverse relationship between their prices and yields. When yields rise, prices fall, and vice versa. Over the last few years, the prices of many TIPS have fallen more than the principal value has adjusted higher, resulting in negative total returns. From December 31, 2021 through May 23, 2024, the Bloomberg US TIPS Index has lost 8.9%. The large price declines more than offset the rise in principal values due to the inflation adjustments.

Those negative returns aren't indicative of the whole TIPS market, especially individual TIPS. Price fluctuations in the secondary market are temporary as long as you hold to maturity. TIPS prices have generally fallen over the last two years, but the principal values have risen. Consider this TIPS that was issued in October 2020, maturing in October 2025: Its inflation-adjusted value has risen to over $1,200 since it was issued, or a 20% increase.

Looking at the secondary market price doesn't tell the whole story, because it doesn't include the inflation adjustment. The chart below illustrates this phenomenon. The blue line represents the price of this TIPS in the secondary market; the red line multiplies that price by the TIPS's inflation index ratio. Initially prices had declined more than the inflation adjustment. Since late 2022, the average price of this TIPS has held relatively steady, allowing the inflation-adjusted price to rise.

There are pros and cons to both holding individual TIPS or investing through a fund. One benefit that individual bonds offer—when holding bonds to maturity—is the ability to "look through" price declines in the secondary market, knowing the bonds will mature at their par value.

Consider once again the TIPS example shown above—it was issued in October 2020 and its inflation-adjusted price is up over 8% since it was issued, and that doesn't consider the semiannual interest payments. Over the same time frame, the Bloomberg US TIPS Index is down 1%.

Consider TIPS if you're looking for long-term inflation protection. With real yields well above zero, investors can finally earn higher income with TIPS while also helping protect against inflation over the long run.

For individual TIPS holders, any potential price declines might not matter if they're held to maturity. For investors who invest in TIPS through exchange-traded funds (ETFs) or mutual funds, the value of the funds can fluctuate, but that doesn't mean you need to abandon your holdings. If yields rise further and the funds rebalance, investors may be rewarded with higher income payments to help offset potential price declines, while additional inflation increases would result in positive principal adjustments to the underlying holdings.