I Bonds are great, but there’s a limit on how much you can buy each year. After you buy all the I Bonds you can buy in your personal account, trust, business, as gifts, from your tax refund, and for your kids, then what? A natural answer is TIPS. They are another type of government bond with inflation protection.
I have a lot to say on this topic because I wrote a book about TIPS back in 2010. Amazingly little has changed in all these years. Specific interest rates changed and some new mutual funds and ETFs came out, but the principles are still the same. I’ll give you the gist of TIPS in this post.
What Are TIPS?
TIPS are Treasury Inflation-Protected Securities. They’re a type of bond issued by the U.S. government. Both the principal and the interest are linked to inflation. If inflation goes higher, you get paid more interest and the principal repayment also goes higher.
No Purchase Limit
The biggest advantage of TIPS over I Bonds is that there’s no annual purchase limit in TIPS. You can buy as much TIPS as you want, in all types of accounts — including IRAs and HSAs, at a broker you already use, both as individual bonds and in a mutual fund or ETF. You don’t have to use TreasuryDirect.
Yield Can Be Negative
The biggest disadvantage of TIPS over I Bonds is that the yield on TIPS can be negative, which means they can be guaranteed to lose to inflation whereas I Bonds are guaranteed to at least match inflation.
The chart above shows the yield on 5-year TIPS from 2010 through April 2022. It turned negative shortly after I published my book in 2010 (great timing, huh?). It stayed consistently positive only between November 2016 and December 2019.
The yield on 5-year TIPS was -0.46% when I first wrote this on April 26, 2022. It means you’re guaranteed to lose 0.46% per year to inflation for five years if you bought a 5-year TIPS on that day and you hold it to maturity. No one likes to lose to inflation but there may not be a better choice after you buy all the I Bonds you can buy. Institutional investors invest billions of dollars in TIPS. They settle for a guaranteed loss to inflation to protect against losing an even larger amount to inflation.
Yield No Longer Negative
The market changes fast. TIPS yields are no longer negative only two months after I first wrote this in April 2022. As I updated this on June 17, 2022, the yield on 5-year TIPS was +0.48%. This means if you buy a 5-year TIPS and hold it for five years, you’ll beat inflation by 0.48% per year. This is better than merely matching inflation in I Bonds.
When TIPS yields were positive in the past, they were higher than the fixed rate on I Bonds. I sold low-rate I Bonds and bought TIPS in 2018 when the yield on 5-year TIPS was +1.1% versus 0% – 0.3% on I Bonds.
The market will continue to change. The yields on TIPS may go up some more, or they may come back down. You can see the latest yields on TIPS of different maturities at Daily Treasury Par Real Yield Curve Rates (click on the second link on the web page) and on this page from Wall Street Journal.
Interest Rate Risk
The next disadvantage of TIPS over I Bonds is interest rate risk.
I Bonds are guaranteed never to lose money regardless of when you cash out. You forfeit the last three months of interest when you cash out within five years but you’re guaranteed to have your principal back plus the interest you get to keep. They behave like a bank CD.
It’s a different story with TIPS. You’re guaranteed to have your principal back only when you hold TIPS to maturity. If you must sell TIPS early, you get the market value, which can be higher or lower than your original investment.
Bond prices go down when market interest rates go up. You can lose money in TIPS over the short term even when inflation is high. For instance, Vanguard Inflation-Protected Securities Fund (VAIPX) invests 100% in TIPS. Its year-to-date return through June 15, 2022 was -7.82%, and that was with the high inflation until that point in 2022. The short-term return was negative because market interest rates went up in those months.
Lesser of Two Evils
Although the -7.82% short-term return on the TIPS fund sounds bad, it was actually better than the returns on comparable non-TIPS bond funds. For instance, the year-to-date return on Vanguard Intermediate-Term Treasury Index Fund (VSIGX) was -9.07% in the same period.
TIPS have interest rate risk but other bonds also have interest rate risk. Those other bonds may also lose to inflation.
Breakeven Inflation Rate
The tradeoff comes down to how much inflation there will be in the future. No one knows. The market participants come out with an estimate. That’s the breakeven inflation rate, which is the difference between the yield on TIPS and the yield on nominal Treasury bonds of the same maturity. You’re better off with TIPS if inflation in the future comes out above this breakeven inflation rate. You’re better off with regular Treasuries if inflation in the future comes out below this breakeven inflation rate.
| Future Inflation | Better Off With |
|---|---|
| > Breakeven Inflation Rate | TIPS |
| < Breakeven Inflation Rate | Regular Bonds |
David Enna at TIPS Watch tracked the breakeven inflation rate at the time when TIPS bonds were first issued versus the actual inflation experienced during their lifetime. The data showed the market is always wrong on what future inflation will be. Sometimes the market estimated too high. Sometimes the market estimated too low.
You see the current 5-year breakeven inflation rate from a chart by the Federal Reserve Bank of St. Louis. It’s between 2.5% and 3.5% at this moment. You don’t know which way they’re wrong or by how much.
When to Invest in TIPS
Most of the questions on TIPS are really on whether it’s a good time to invest in TIPS right now.
Is it the best time to invest in TIPS right now?
It’s not. The best time to invest in TIPS was October 2008 when you could lock in a positive 3% yield above inflation for 20 years but we don’t have a time machine.
Should I wait until TIPS yields go higher in the coming months?
No one knows whether the yields on TIPS will go higher or lower. Money waiting in the wings also loses to inflation.
Is it better to switch from other bonds to TIPS now when inflation is high?
No one knows. High inflation isn’t a secret. When everyone expects high inflation, the breakeven inflation rate is also higher. This compensates investors in other bonds for their lack of inflation protection.
Market participants collectively come to a conclusion that the current yields on TIPS and other bonds make them no better off or worse off one way or the other. You’re better off in TIPS when the market underestimates future inflation but no one knows whether the market is underestimating or overestimating right now.
Handicapping whether inflation in the coming years will be above or below the current breakeven inflation rate isn’t a good way to invest.
Then how do you decide whether to invest in TIPS right now or not?
You decide by whether you want inflation protection or you want to take your chances relative to inflation.
When you invest in TIPS, you know how much you’ll earn or lose over inflation. Invest in TIPS if you’re satisfied by this number no matter what inflation turns out to be in the future. Other fixed-income investments may end up doing better or doing worse than TIPS but you don’t care. Your goal is to protect your investments from inflation.
On the other hand, if you don’t mind losing to inflation for a chance to beat more, you don’t need to go out of your way to invest in TIPS. No one knows whether TIPS will do better or worse.
Finally, there’s always diversification. You don’t have to go either 100% TIPS or zero TIPS. You can invest in both TIPS and other bonds.
How to Invest in TIPS
If you decide to invest at least some money in TIPS, you can either buy individual TIPS or buy a mutual fund or ETF that holds TIPS. Buying a mutual fund or ETF is the easiest, in the same way as you invest in other bonds. When you’re new to TIPS, start with a mutual fund or ETF.
The popular total bond market index funds and ETFs don’t include TIPS. Investing in both a TIPS fund and a total bond market index fund or ETF will make your bond investments more complete.
As in other bonds, short-term TIPS have a lower interest rate risk than longer-term TIPS but, in general, they also have a lower yield. These funds invest in short-term TIPS (maturities up to 5 years):
| Minimum Investment | Expense Ratio | |
|---|---|---|
| iShares 0-5 Year TIPS Bond ETF (STIP) | None | 0.03% |
| Vanguard Short-Term Inflation-Protected Securities ETF (VTIP) | None | 0.04% |
| Vanguard Short-Term Inflation-Protected Securities Index Fund (VTAPX) | $3,000 | 0.06% |
These funds invest in TIPS of all maturities:
| Minimum Investment | Expense Ratio | |
|---|---|---|
| Fidelity Inflation-Protected Bond Index Fund (FIPDX) | None | 0.05% |
| Schwab Treasury Inflation Protected Securities Index Fund (SWRSX) | None | 0.05% |
| Schwab U.S. TIPS ETF (SCHP) | None | 0.05% |
| Vanguard Inflation-Protected Securities Fund Admiral Shares (VAIPX) | $50,000 | 0.10% |
Buying individual TIPS gets more complicated. Please read my book Explore TIPS if you’re interested in buying individual TIPS.
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Walt says
As an alternative, I bought 2-year Treasury notes yielding 2.5% after maxing out my I-Bond purchase.
RobI says
One thing that’s confusing me is what dividend gets paid out with TIPS. Would the actual $ amount be the rate of inflation less the effective yield so roughly (8.5%-0.5%)?
This still seems a heck of a lot better than regular bonds right now but maybe I’m missing something!
Harry Sit says
The dividends from a fund are more complicated than a simple yield-plus-inflation calculation due to capital gains and losses within the fund but, in general, the dividend distributions go up with inflation. For instance, the Schwab fund SWRSX distributed $0.61 per share in the last 12 months. That comes out to about 5.2% of the current share price.
pdb says
If you’re paying taxes each year on the increase in the principal from the inflation adjustment, have you factored into your personal yield the present value of taxes that must be paid on money not received for xx years, or am I incorrect in thinking this isn’t taken into account?
Harry Sit says
When you invest in TIPS through a mutual fund or ETF, the fund pays out the increase in the principal value each year. Taxes work the same as in any other bond fund.
VictoriaF says
As of May, 08, 2022, comparing Vanguard’s short-term (VTAPX) and regular (VAIPX) TIPS funds:
– in the past 1 year VTAPX (2.95%) > VAIPX (0.59%), and
– in the past 3 years VAIPX (5.27%) > VTAPX (4.16%).
Why did VTAPX outperform VAIPX in the last 1 year?
In my Roth IRA, I want to have a “safe” fund that won’t lose to inflation in the long run. I don’t have any specific dates that I need to match with this fund’s duration. Will I be safer with VTAPX or VAIPX?
Harry Sit says
Both the short-term TIPS fund (VTAPX) and the all-maturity TIPS fund (VAIPX) are indexed to inflation in the same way. In general, the short-term fund has lower risks and lower returns than the all-maturities fund. Neither is guaranteed not to lose to inflation in the long run. When the yields were negative a year ago, both lost to inflation. The short-term fund lost more. The all-maturities fund lost less.
Interest rates rose in the last 12 months, especially since January 2022. This caused the all-maturities fund to do worse than the short-term fund. It will continue this way if interest rates continue to rise in the next 12 months. When interest rates stop going up and stay there (or start going down), the all-maturities fund will do better than the short-term fund.
It isn’t a good way to invest by predicting whether interest rates will continue to go up, when they will stop going up, or when they will start going down. The all-maturities fund has a better chance not to lose to inflation in the long run (lose less or beat more) than the short-term fund but it comes with a higher interest rate risk, as you’ve seen in the last 12 months.
Old mariner says
Hi Harry, do you have any thoughts about the 10-yr TIPS auction on May19th? Good time to buy, not a good time to buy? I read one analyst (David Enna) thinks it’ll go positive. I’m looking for somewhere to park some cash for my older-than-now years. I’m maxxed out on i-bonds.
Harry Sit says
The yield is currently positive at about +0.25%. It’s higher than it was two weeks ago but lower than it was one week ago. As in investing in anything else, you’re always taking a chance that the price will go lower after you buy or that something else would’ve done better. I can’t predict whether the yield will go higher or lower in the near future if you wait or whether you’ll realize in 10 years it did better or worse than a regular 10-year Treasury.
George says
When a TIPS is purchased at a reopening (and accrued interest and accrued inflation is paid), will the purchaser receive at maturity all accumulated inflation (OID) beginning from the reopening issue date, or instead, beginning from the original issue or dated date?
Harry Sit says
The way you expect to be fair. Suppose the bond was issued for $1,000 and by the time you buy it, inflation has made the original $1,000 worth $1,100. So you pay $1,100. If inflation makes that $1,100 worth $2,200 when the bond matures, you get $2,200.
George says
Thank you. Then, unlike accrued interest paid (recovered at the next coupon date), accrued inflation paid is never recovered later. So to be fair, is the accrued inflation ($100) able to be amortized (along with any other premium in other cases) over the remaining term of the reopened TIPS (to offset the $1100 taxable inflation OID and coupon interest paid)?
Harry Sit says
Accrued inflation works similarly to accrued interest, just on a longer time frame. It is recovered. Suppose someone bought at the original issue for $1,000 and you bought at the reopening for $1,100. Both of you will receive $2,200 when the bond matures. You can see it as receiving the full $1,200 that recovers the $100 accrued inflation you paid, similar to how the next interest payment recovers the accrued interest.
George says
Thank you for the 5/26 response. I know we must pay tax on the inflation increase in premium in each tax year. In your example above, suppose the TIPS goes on to have $400 in inflation-increased principal between reopening, when I paid $1100 to buy it, and year end, i.e., it gained $500 overall since the original issue price of $1000 in that same tax year. Since I will be repaid at maturity the accrued inflation of $100 that I paid at purchase, do I now need to pay tax on the full $500, or only on my gain of $400?
Harry Sit says
You will pay tax only on $400.
DB says
If you purchase TIPS in a Traditional IRA and then want to do a Roth conversion, does it require selling the TIPS in Traditional IRA and repurchasing them in Roth IRA or do the shares get moved in-kind from Traditional IRA to Roth IRA and you pay taxes on the conversion as usual?
Harry Sit says
It doesn’t require selling and repurchasing. The assets move in-kind and you pay taxes on the dollar value. This is the same for all assets, not just TIPS.
George says
If I buy a $1000 face value 5-yr. TIPS at auction in April at negative yield-to-maturity (YTM) and premium of $100, I’ll get the minimum .0625% interest in October, and inflation adjustment on $1000 from April to Dec. I owe tax on the interest and the inflation, but may offset these by allocating the $100 premium over my years of the TIPS ownership: for April to Oct., I can allocate $0.625-$1100*YTM (positive, as YTM is neg.). Q: Can I alloc. prem. for Oct. to Dec., or must wait a yr. & use full period ending April?
Harry Sit says
The accrual period used in calculating premium amortization must have a scheduled payment of principal or interest on the first or the final day. Therefore if you allocate April to October, you can’t allocate October to December (no scheduled payment during this period). See IRS Publication 550. In practice, just go by the bond premium number reported on your 1099. You don’t have to calculate it yourself.
DB says
I had a question about calculating Market Discount. In the Explore Tips book, it isn’t clear if the example provided used adjusted price or unadjusted price as they both are the same in the example used. Which one should be used for calculating market discount?
Is Market Discount reported by the brokerage firm if you buy TIPS in a taxable account at a Brokerage?
DB says
The example used in the book is $10,000 * (1.00000 – 99.811 / 100) = $18.90
I assume 1.0000 is the index ratio on the date of issue? Is 99.811 adjusted or unadjusted price?
Harry Sit says
You use the adjusted price. Brokers are supposed to report the market discount when you sell or when the bond matures.
DB says
Thanks Harry for the clarification on market discount.
Regarding reporting Original Issue Discount for the year of maturity of TIPS matures, I assume one subtracts the inflation index on 1/1/2027 from inflation index for the date of maturity?
Assume that the TIPS matures on 4/15/2027. Is it correct to subtract inflation index on 1/1/2027 from the inflation index on 4/15/2027 rather than 1/1/2028?
Harry Sit says
That’s correct. The OID stops on the maturity date.
George says
Regarding your May 26, 2022 at 1:49 pm response on reopenings, here is a question. Your response said: Suppose the bond was issued for $1,000 and by the time you buy it, inflation has made the original $1,000 worth $1,100. So you pay $1,100. If inflation makes that $1,100 worth $2,200 when the bond matures, you get $2,200.
Q: If the reopening bid price is $1050 instead of $1000, the accrued inflation is applied by idx ratio 1.1, and I paid 1050*1.1=$1155. Is the extra $55 accrued inflation I paid ever recovered?
Harry Sit says
The price is $1,050 when the yield is lower than the stated interest rate on the bond (the “coupon”). That’s a bond premium, not accrued inflation. You get the extra $50 back in small bits and pieces from each interest payment over the remaining life of the bond.
George says
Thank you for the above response; I mistyped $55 in the last line, but meant $5. To clarify the question, initial issue price is at par of $1000 and index ratio is 1.0, then at the (later) reopening, the index ratio for inflation is 1.1, and the auction price is $1050, and the total cost is $1155 after accrued inflation. The accrued inflation is multiplied to get $1155 (NOT added to get $1150). Q: Is the extra $5 of accrued inflation ever recovered? Thanks!
Harry Sit says
It’s easier to think in constant dollars in TIPS. Treat them as a different currency if that’s helpful (think “Euros”). The bond premium is 50 “Euros” worth $55 today. When the 50 “Euros” is paid back in bits and pieces through interest payments, so is your $55. There’s no extra $5. The $50 and the $55 are the same thing, just in different units.
Lizzie says
New to TIPS here. Say I buy $100 of TIPS paying 2% and after 6 months the inflation adjustment is 5%, does this mean that my principal is now $105 & interest earned is $1.05? Am I understanding this correctly – everything is done on a six month basis?
Harry Sit says
Yes, and you don’t have to worry about those details when you buy a TIPS fund, which I recommend for people new to TIPS.
Lizzie says
Thank you Harry
Mary says
I just bought your TIPS book and started following your instructions on how to find out what the purchase price will be. The book is well-written and the links I have used so far all work! I really like the Pricing worksheet. So just to make sure I understand this correctly, in your example in the Pricing worksheet, if I had placed an order for $10,000, then my purchase price would be around $11,111 correct?
I wanted to practice using the worksheet, so I used the current auction announcement for 10-year TIPS. I entered the information from the announcement and used .46% for the yield. The price per bond comes out to 996.78482, which means it will be less than the order amount, correct?
I’m planning to buy 5-year TIPS in the October auction, so I still have time to learn more about it. In your blog here, you say something about if the yield is negative, it may not keep up with inflation. But I thought I heard that TIPS are guaranteed to at least beat inflation (if you hold them to maturity), so I’m confused about that. The yield for 5-year notes is .46 now so maybe that’s not an issue.
Harry Sit says
That’s correct. The best way to practice is to use it on completed auctions in the past. You can then compare the worksheet with the actual results.
When I first wrote this in April, the yield on the 5-year TIPS was negative. It has turned positive since then. If the yield is negative, holding to maturity will still trail inflation. If the yield is positive, holding to maturity will beat inflation.
Mary says
Thanks Harry. I’ll wait to see what the auction results are later this week and do the calculations you talk about in “Read the Auction Result”. Then I’ll see what the final price is and compare it to the price from the worksheet.
For a new issue, can there be a discount or premium, or is that just for a reopening?
Harry Sit says
There will be a slight discount because the coupon rate is rounded down to the next 0.125% increment from the yield (minimum 0.125% when the yield is negative or lower than 0.125%).