Treasury Inflation-Protected Securities can preserve your investment when the value of a dollar decreases

• Treasury Inflation-Protected Securities (TIPS) are issued by the US government.
• The principal value of TIPS is linked to the Consumer Price Index (CPI). 
• TIPS can be a good hedge against inflation, but there are downsides to consider. 

Treasury Inflation-Protected Securities (TIPS) are a type of US Treasury bonds with face values that are indexed to inflation. When inflation rises or falls, the principal value adjusts with it. 

The US government issues TIPS, but these investments aren't risk-free. It's important to understand how TIPS work as well as the benefits and risks before investing. 

How do TIPS work? 

Inflation causes a gradual increase in the cost of goods and services, so your money won't go as far. When inflation rises, you'll be able to buy fewer goods and services in the future than you can today.

And inflation can have a negative impact on your investments, especially if you have regular Treasury bonds. The interest rate paid is fixed for the life of the bond, so the interest payments may not keep up with inflation. 

If the rate of inflation exceeds the interest rate on your bonds, you're losing money on your investment. That's why some investors choose TIPS to diversify their portfolios.

"TIPS are like other government-issued bonds that pay you a percentage yield based on the bond principal," explains Katherine Fox, a CFP® professional and investment and philanthropic advisor at Arnerich Massena, Inc. 

The main difference between TIPS and other government bonds, however, is that when you invest in TIPS, your principal rises with inflation and decreases with deflation. "As inflation increases, the face value of TIPS also increases. Although you are still being paid a set yield, that yield will increase as the face value increases with inflation," Fox says. 

TIPS are tied to the Consumer Price Index (CPI), which affects your interest and the price you're paid when the TIPS mature. That means they can help combat inflation risk more than other investment vehicles.

And since the rate is tied to the principal, your interest payments can vary. To calculate the value of a security you already own, you can check the issue date with TreasuryDirect. 

Advantages and disadvantages of TIPS

The main benefit of TIPS is that they are protected during periods of high inflation since the face value of TIPS holdings will increase at the same rate as the CPI. And TIPS are among the few investments that can outperform inflation while still being backed by the US government. 

However, the fact that your principal will increase with CPI can also be a disadvantage, according to Jason Blumstein, a chartered financial analyst (CFA) and founder of Julius Wealth Advisors. That's because the principal increase is subject to federal taxes, even though you don't receive it until you sell or the bond matures, he explains. 

And Fox notes that TIPS are not an investment guaranteed to increase during periods of high inflation. Investors' future view of inflation also plays a big role in the performance of TIPS in the secondary market, where they are bought and sold after the government initially issues them.

For example, Fox explains, as inflation was rising to 40-year highs in mid-2022, the secondary market value of TIPS was decreasing because investors expected inflation to decline significantly in the the coming years. 

And since TIPS are indexed based on inflation, this can be a drawback during deflationary periods. The face value of TIPS will decrease as the CPI decreases. And because the payments are dependent on inflation, it's hard to anticipate your income, which can lead to unpredictable cash flow.

Tax treatment of TIPS 

Fox says that TIPS do provide investors with certain tax benefits as principal increases and interest payments are exempt from state and local taxes. 

According to Blumstein, new investors should consider the tax ramifications of TIPS where the principal increase is taxed though no actual income is produced. He says investors should also analyze the TIPS breakeven for the respective maturity. 

"If inflation is higher than the TIPS breakeven, the investor will be better off owning TIPS versus Treasuries," he explains.

But if it's below, investors may be better off owning regular Treasuries.

How to buy TIPS

You can buy TIPS by opening an account with TreasuryDirect or a banker or broker. TIPS are sold at auction, and you can bid on them in two ways — through a non-competitive or competitive bid. 

A non-competitive bid means that you agree to accept the yield determined at auction. That means you're guaranteed to receive the tips you want in the full amount you bid on. 

If you place a competitive bid, you'll specify the yield you want to receive. Your bid will either be accepted in the full amount you want or less than you wanted. Your bid may also be rejected if the yield you want is higher than the yield set at auction.

According to TreasuryDirect, TIPS are issued in five-, 10-, and 30-year terms and sold in increments of $100. Once you purchase TIPS, you can either hold them until they mature or sell them in the secondary market. 

You can also hold TIPS through a mutual fund or exchange-traded fund (ETF). This can give you more diversification, but since there's no maturity date, there's no guarantee as to what the prices will be in the future.