These securities are issued several times during the year in maturities of five, 10 and 20 years. The principal value of the
TIPS is adjusted annually for inflation, and that, in turn, affects the interest payments.
TIPS is adjusted annually for inflation, and that, in turn, affects the interest payments.
The coupon payments from TIPS are subject to ordinary income tax. One of the drawbacks of TIPS is that the principal adjustment is subject to ordinary income tax as well, in the year that it is made, though there is no cash distribution to draw the tax payment from. For example, if the value of a $10,000 bond is raised to $10,250 to account for 2.5% inflation, that $250 adjustment is fully taxable. Because this situation can create a cash flow problem for meeting the tax obligation, often TIPS are recommended for tax-deferred accounts, such as IRAs.
In the event of deflation, the value of TIPS will decline. However, the redemption will be at face value, and the dividend can’t fall below zero, so there is a deflation hedge built in as well.
When they were first introduced, $31 billion was invested in TIPS. Last year, the Treasury issued $186 billion worth of TIPS, bringing the total balance to $2 trillion. For the first 24 years of their existence, through January 2021, the annualized rate of increase in the consumer price index was only 2.09%. TIPS are traded on the secondary market. Their price fluctuates with changes in interest rates as well as changes in the inflation rate. When inflation surged beginning in the spring of 2021, TIPS prices did not react as expected. A recent article in Morningstar explored the subject [“When Inflation Surfaced, TIPS Flopped,” January 2023, page 10]. Buyers
wanted TIPS, and they bid up the prices to the point that the real yield became negative.
wanted TIPS, and they bid up the prices to the point that the real yield became negative.
Some investment funds include TIPS among their holdings, and some funds specialize in TIPS. Funds can provide for diversification of maturities and easy reinvestment choices. On the other hand, funds do not have a maturity date, and so can present risks not present when TIPS are owned outright.
After dipping negative, TIPS yields are positive again
The graph below shows the inflation-adjusted yields on 10-year TIPS from January 1, 2003, to March 16, 2023. The yield fell into negative territory after the brief recession induced by the pandemic, and stayed negative as inflation emerged. The yield became positive in May 2022, and has since reached levels not seen in more than a decade.
© 2023 M.A. Co.
