TIPS: Inflation Linked Bonds
October 20, 2006 by TFB[Last updated on July 14, 2008: Added links to follow-up posts.]
TIPS, or Treasury Inflation-Protected Securities, is a kind of bond issued by U.S. Treasury with principal and interest linked to inflation. Regular, or in bond-speak, “nominal” bond is an IOU. You lend the government $100 for a set term. They pay you interest every 6 months and repay you $100 when the term ends. The biggest enemy to nominal bonds is inflation. Over time, inflation eats away the value of the interest and the repaid principal. A 6% CD sounds good if the inflation is 2%, but not so good if the inflation is 5%. With TIPS, both the principal and the interest payments go up with inflation. You are guaranteed a “real” interest rate after inflation whether the inflation ends up being 2% or 5%.
Like regular Treasury notes, TIPS are totally safe and the interests are exempt from state and local income tax because they are issued by the U.S. Treasury. Of course because some inflation is expected, the quoted yield on TIPS is lower than that on regular bond of the same term. For example right now yield on 5-year TIPS is about 2.6%. Yield on 5-year Treasury note is about 4.75%, implying a 2.15% expected inflation for the next 5 years.
TIPS are sold in $100 increments. You can buy them in a mutual fund too. There are 5-year, 10-year, and 20-year term TIPS. Although you can sell them before maturity, you will have to pay a fee and receive the going market price at a gain or loss relative to the price you paid if you sell prematurely. The Treasury Department sells TIPS in auctions, very much like how Dutch auctions on eBay work. Institutions (read “big money”) submit bid to the Treasury for how much they want to buy and how much they want to pay. Us small fish get to tag along with “non-competitive bids.” When the auction settles, everybody pays the same price, including big guys and us small guys. This is the only place I know in financial services where retail investors are on equal footing with the big guys. Being able to pay the same price those big guys pay somehow makes me feel good.
Inflation linked or not, this is still bond money. You get a small return after inflation. You don’t necessarily get “rich” on this kind of stuff. Because it’s bond money, you typically hold them in a Traditional IRA (rollover from your previous 401k/403b) or Roth IRA unless you run out of room there or if you are saving for a short term for a car, home down payment, etc. If you want to buy TIPS in a regular taxable account, you can either buy from the Treasury directly using TreasuryDirect, or use a brokerage account. If you want to buy in an IRA, you must use a brokerage account because TreasuryDirect doesn’t handle IRAs. Either way, I recommend Fidelity Investments, the TFB Award winner in this category. Fidelity charges no fee for online orders for TIPS at auction or on the secondary market.
Right now Treasury sells TIPS four times a year in January, April, July and October. You will have to know when they hold the auction because the window for placing orders is only a few days. Take a look at the Tentative Treasury Auction Schedule and see when TIPS are coming up for auction or subscribe to my RSS feed for upcoming Treasury auctions. I also have RSS feeds for the current yield on TIPS and regular Treasurys of different maturities.
[Update on May 30, 2008]: I created this online spreadsheet on Zoho. You can use it to estimate how much cash you will need for buying TIPS at auction.
There will be an auction for a 4-year 6-month TIPS next week. I’m buying some because I find the expected 2.6% real yield appealing. I estimate that stocks probably will return 4% after inflation. So 2.6% risk-free is not bad at all.
There are many fine details on how TIPS really work. You don’t necessarily have to know unless you are also a finance buff like me. You have to first decide whether you want to TIPS at all:
- what is your goal?
- how much money are you allocating to bonds?
- how do you want to hold the bond money, in a balanced fund, a separate bond fund, or individual bonds?
If you like TIPS, read more about them at TreasuryDirect. The Bond Market Association also provides a good tutorial on InvestingInBonds.com.
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