Rising inflation boosts appeal of TIPS for income investors

Rising U.S. consumer prices have increased demand for Treasury Inflation-Protected Securities as income investors seek ways to preserve purchasing power and maintain real returns.

TIPS adjust their principal and the interest payments that are calculated on that principal to the U.S. Bureau of Labor Statistics’ Consumer Price Index for All Urban Consumers. They pay a fixed coupon rate applied to inflation-adjusted principal. At maturity investors receive either the inflation-adjusted principal or the original principal, whichever is greater. The U.S. government backs principal and interest payments on Treasury securities.

Market participants compare TIPS to nominal Treasuries using the break-even inflation rate, which is the yield difference between a nominal Treasury and a TIPS with similar maturity. When expected inflation exceeds the break-even rate, TIPS historically have the potential to deliver higher total returns than comparable nominal Treasuries. In recent months rising consumer prices and movements in break-even rates have narrowed the gap for some maturities, prompting some income-focused investors to reassess allocations to inflation-protected debt.

The inflation adjustment increases the principal amount on which coupon payments are calculated, so coupon payments rise as the CPI increases even though the coupon rate remains fixed. Investors can buy individual Treasury TIPS across maturities or access TIPS through mutual funds and exchange-traded funds to match duration and cash-flow targets.

There are trade-offs. TIPS typically have lower nominal coupon rates than comparable nominal Treasuries, producing smaller cash coupon payments when prices are stable. Inflation adjustments are taxable as ordinary income in the year the adjustment occurs, creating tax liabilities known as phantom income if the securities are held in taxable accounts. Financial advisers commonly recommend holding TIPS in tax-advantaged accounts such as IRAs or 401(k) plans to avoid those annual tax bills.

Duration and liquidity affect risk and suitability. Longer-duration TIPS offer stronger protection against sustained inflation but are more sensitive to moves in real yields and can show greater price volatility. Shorter-term TIPS lower interest-rate sensitivity but provide less coverage against prolonged inflation. Liquidity is highest for on-the-run Treasury issues and widely traded TIPS funds; less frequently issued maturities can have wider bid-ask spreads.

The Treasury first issued TIPS in 1997 to give investors a way to limit inflation risk in the government bond market. Pension funds, endowments and individual investors use TIPS to match liabilities that are sensitive to inflation.

Market participants monitor real yields, break-even inflation rates and tax rules when evaluating TIPS. Rising headline inflation increases the theoretical benefit of inflation protection, while the actual performance of TIPS will depend on future inflation and changes in nominal and real interest rates.