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% as I 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.
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. As I wrote this, although the 5-year TIPS yield was still negative, it wasn’t as negative as before. It was -1.6% only 1-1/2 months before. The 10-year TIPS yield was barely negative at -0.08% at this moment. By the time you read this, the yields may not be negative anymore.
If TIPS yields become positive, this disadvantage can turn into an advantage. 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.
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 April 25, 2022 was -4.41%, 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 -4.41% short-term return on the TIPS fund sounds bad, it was actually a lot 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 -6.81% in the same period.
TIPS can lose to inflation but other bonds can lose more to inflation. When TIPS yields are negative, after buying all the I Bonds you can buy, your choice isn’t losing to inflation or not losing to inflation. It’s losing a known amount to inflation with TIPS or losing an unknown amount to inflation with other bonds.
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 3% 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?
Absolutely 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 high. 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 more to inflation for a chance to lose less, 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 mutual fund and ETFs invest in short-term TIPS (maturities up to 5 years):
| Minimum | 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 mutual funds and ETF invest in TIPS of all maturities:
| Minimum | 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.