Tips on TIPS: Treasury Inflation Protected Securities

Inflation remains low, but concern about future price levels has stoked demand for TIPS.

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TIPS, short for Treasury Inflation-Protected Securities, offer investors the closest thing Uncle Sam has to a sure bet these days. These bonds have the full backing of the U.S. government and provide investors with returns that will keep pace with future rates of inflation, as measured by the U.S. Consumer Price Index. You can buy them directly from the government, but it's easier—and a better investment decision in many cases—to buy low-fee investment funds that hold TIPS.

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TIPS are recommended for their safety and because of widespread concern about the inflationary implications of record government deficits and expansionary Federal Reserve Board policies. The U.S. Treasury says the public held $681.2 billion in outstanding TIPS at the end of July, up about $105 billion over the previous 12 months.

How they work. TIPS are sold at auction several times a year. The maturities of TIPS sold recently have been five, 10, and 30 years. They pay a fixed rate of interest, but that rate is applied to a fluctuating principal amount of a TIPS bond, which rises with inflation or falls with deflation. Interest payments are made every six months. Although TIPS are generally touted as protection against inflation, they also offer some protection against deflation. That's because TIPS guarantee to pay at least their original principal at maturity. Put another way, if prices double during the life of a TIPS bond, a $1,000 TIPS would automatically rise to a principal value of $2,000. If prices fall by 50 percent, however, that $1,000 bond would still have a principal of $1,000. Find more details about TIPS at Treasury Direct.

Taxes. Income from TIPS comes in the form of interest payments as well as any annual inflationary increase in the principal value of the bond. These gains are exempt from state and local taxes, but not federal taxes. For most people, this means TIPS should be held in a tax-advantaged retirement account.

Fund choices. These days, more people are buying ETFs—exchange traded funds—that invest in a variety of TIPS. There also are low-cost TIPS mutual funds. Examples include the iShares Barclays TIPS Bond Fund, one of the category's largest ETFs, and Vanguard Inflation-Protected Securities, a large TIPS mutual fund. PIMCO and BlackRock are other leading provider of TIPS funds.

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Funds versus direct purchases. If you use a broker to buy TIPS directly for your retirement account, you'll pay a purchase commission but not an ongoing management fee (as you would with a TIPS fund). Still, fund fees are not steep. Both the Barclays and Vanguard funds charge about two-tenths of 1 percent. ETFs, which charge commissions when you buy or sell holdings, could become costly if you change your TIPS holdings frequently. Mutual funds generally allow cheaper conversions, but you should check out the details before investing in either an ETF or mutual fund TIPS account. Investors in TIPS funds have the option of automatically buying more shares with their earnings, and most do. That's not possible with direct TIPS ownership. So, it's easier for fund holders to keep their TIPS earnings fully invested. Direct owners of TIPS would have to reinvest their interest payments in other TIPS to enjoy similar benefits.

If you invest in a TIPS mutual fund or ETF, you'll receive interest income either monthly or quarterly, depending on the fund's practices. If you own the funds outright, you get paid every six months. The big difference between the direct purchase of TIPS and buying them through a fund is in the handling of any inflation-adjusted increases in the principal of your TIPS holdings. Gains for funds and direct ownership will trigger annual taxable income. But if you own TIPS directly, you'll be on the hook for paying taxes on any principal appreciation during the year even though your gains are "phantom income" (in that you won't actually receive those gains in principal until your TIPS mature). Funds are required by law to distribute your principal gain to you, so you will be receiving those actual payments as you go.

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TIPS funds hold a variety of issues with different interest rates and maturities. Holders need never worry about seeing their holdings mature, as the funds will be regularly replenishing their portfolios. Direct owners of TIPS will face maturity events, however, and may need to own an assortment of TIPS so that their income receipts are smoothed over time.

The deflation promise. If you're worried that prices may fall and you want to take advantage of TIPS original principal guarantee, consider buying new TIPS directly from the Treasury at an upcoming auction. That's because the funds that hold TIPS purposefully hold a variety of maturities, including some TIPS that were issued five or even 10 years ago. Those earlier TIPS have already experienced a cumulative CPI-driven boost in their principal values. If deflation does become a problem, investors in an existing basket of outstanding TIPS will lose a lot of principal before hitting their original principal guarantees. On the other hand, people who are that worried about long-term deflation should probably be looking for investments elsewhere than in TIPS.

Twitter: @PhilMoeller