TIPS, or Treasury Inflation-Protected Securities, is a type of bond issued by the U.S. Treasury with principal and interest linked to inflation.
A regular, or in bond-speak, “nominal” bond is an IOU. You lend the government $1,000 for a set term. They pay you interest every 6 months and they repay you $1,000 when the term ends.
The biggest enemy of nominal bonds is inflation. Over time, inflation eats away the value of the interest and the repaid principal. A 4% CD sounds good if the inflation is 2%, but not so good if the inflation is 8%. 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 8%.
Like regular Treasury notes, TIPS are totally safe and the interest is 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 a regular bond of the same term. For example, when the yield on a 5-year TIPS is about 1.6% and the yield on a 5-year Treasury note is about 4%, this implies a 2.4% expected inflation for the next 5 years.
TIPS are sold in $1,000 increments. You can buy them in a mutual fund too. There are 5-year, 10-year, and 30-year term TIPS. Although you can sell individual TIPS before maturity, you will 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. Institutions (read “big money”) submit bids to the Treasury for how much they want to buy and how much they want to pay. Retail investors get to tag along with “non-competitive bids.” When the auction settles, everybody pays the same price. This is the only place I know in financial services where retail investors are on equal footing with the big guys.
Inflation linked or not, this is still bond money. You get a small return after inflation. You don’t necessarily get “rich” on TIPS. Because it’s bond money, you typically hold them in a Traditional 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 buying in a brokerage account. Vanguard, Fidelity, and Charles Schwab charge no fee for online orders for TIPS at auction or on the secondary market.
Right now Treasury sells TIPS every month. 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.
There are many fine details on how TIPS really work. You don’t necessarily have to get into the weeds. You have to first decide whether you want to buy TIPS at all:
- What’s 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.
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