TIPS, issued by the U.S. Treasury, are Treasury Inflation-Protected Securities.
TIPS are a way for investors to help manage the risks of inflation, and since they are backed by the full faith of the U.S. government, they are seen as being free of credit risk, explains Bill Harris, co-founder and CEO of Personal Capital. In other words, investors are guaranteed to receive all of the interest and principal that's coming to them.
Basically, the principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.
Because TIPS are indexed to changes in inflation, the inflationary pressures that affect regular bonds leave TIPS largely unharmed. So when interest rates on regular bonds rise because of inflation, the interest rates on TIPS will remain relatively stable.
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However, there are some trade-offs with TIPS, Harris says. The most obvious is that the interest rate you get on TIPS is much lower than on regular bonds.
That's because with regular bonds, the interest payments are what compensate you for inflation risk, while TIPS back-load the impact of inflation into the maturity payment.
So, while TIPS are structured to outpace the inflation rate, they could also generate poor returns if inflation dips.
For investors with longer investment horizons who are concerned about inflation, TIPS can make sense as a way to help protect against future inflation. Of course, investing in TIPS may not be right for everyone, Harris says. He urges investors to do their research to make sure TIPS are a good fit for your portfolio.