Are TIPS Worth Considering Now? (2024)

Inflation has risen at its fastest rate in decades, but Treasury Inflation-Protected Securities are still down sharply this year. What gives?

Treasury Inflation-Protected Securities, or TIPS, can help protect against inflation over the long-run, but over the short run, their performance may be dictated more by price declines in the secondary market than by the inflation-driven principal adjustment. That's been the case so far this year.

When considering TIPS, it's important to understand their unique characteristics and complex nature. Below we'll discuss what drove the performance this year, and what investors can expect going forward. While the start of the year has been forgettable for TIPS investors, yields are now back in positive territory, and TIPS can help play an important role in protecting your portfolio from inflation over the long run.

TIPS are a type of Treasury security whose principal value is indexed to inflation. As the level of the Consumer Price Index (CPI) rises and falls, so too does the value of a TIPS. Like traditional Treasury securities, TIPS have fixed coupon rates based off of the principal value—so coupon payments rise or fall with the level of the CPI as the principal value fluctuates.

This characteristic helps TIPS protect investors against the effects of inflation, because they'll be rewarded with a higher principal value at maturity as well as growing coupon payments if inflation is rising. (Traditional Treasuries simply mature at their $1,000 par value.) The opposite is true as well: In deflationary periods, the principal value of a TIPS will fall, resulting in smaller coupon payments. At maturity, however, a TIPS investor would receive either the adjusted higher principal or the original principal value. In other words, TIPS never pay back less than the initial principal value at maturity.

The total return of a TIPS over a specific time period consists of income payments, price change, and the inflation adjustment to its principal value. The TIPS index is down this year because the inflation adjustment to TIPS principal values has been more than offset by the drop in TIPS prices. TIPS are still bonds, and their prices and yields move in opposite directions.

The Bloomberg U.S. TIPS Index lost 5.9% through May 18, 2022. The plunge in TIPS prices was the culprit—the average price of the TIPS index closed 2021 at $114.2 and then fell to $104.0, a decline of 8.9%. The rise in the CPI has helped offset some, but not all, of that price decline, as has the 0.22% year-to-date coupon return. (TIPS generally have low coupon rates given the low or negative TIPS yields.) In short, the year-to-date rise in the Consumer Price Index hasn't been enough to offset the steep price declines.

While those low, or even negative, "real" yields might not sound too attractive, consider the yields on nominal Treasuries. The 5-year nominal Treasury offers a yield of roughly 2.8%, but when the high rate of inflation is factored in, that inflation-adjusted yield is well below zero.

A low "real" yield can still produce high nominal returns. Consider the 10-year TIPS, which currently yields roughly 0.12%. If held to maturity, the inflation adjustment must be considered as well. If inflation averages 3% over the next 10 years, for example, the annualized nominal total return would be closer to 3.12%.

While the rise has presented investors a more attractive entry point, TIPS yields could still rise a bit further. While nominal Treasury yields are close to their peaks from the last Federal Reserve rate hike cycle, TIPS yields remain below the pre-COVID-19, five-year average. As the Fed pares back its TIPS purchases as it embarks on quantitative tightening, and if inflation expectations decline, TIPS yields could keep rising, potentially pulling prices even lower.

TIPS can be compared to nominal Treasuries through the breakeven inflation rate. The breakeven rate is the difference between the yield of a nominal Treasury and the yield of a TIPS with a similar maturity. TIPS yields tend to be lower than nominal Treasury yields because investors can benefit when inflation rises, as the principal values adjust higher; nominal Treasury principal values and coupon payments are fixed regardless of the level of inflation.

For TIPS investors, the breakeven rate can be considered a hurdle rate—it's what inflation would need to average over the life of the TIPS for it to outperform the nominal Treasury. The 10-year breakeven rate is currently around 2.7%. If the CPI averages more than 2.7% for the next 10 years, then the TIPS would outperform the nominal 10-year Treasury. Likewise, if CPI averaged less than 2.7%, then the nominal 10-year Treasury would outperform.

Consider TIPS if you're worried that inflation will remain high or if you're looking to help protect against an unexpected rise in inflation. With TIPS principal values indexed to the rate of inflation, they can help portfolios keep pace with inflation in a way that most other investments can't.

Most importantly, remember that TIPS can help protect portfolios from inflation over the long run, but over the short run price fluctuations may be the key driver of performance. Many TIPS yields are now positive, which makes them more attractive, but there's a risk that yields will continue to trend gradually higher and prices decline. For individual TIPS holders, any potential price declines might not matter if they're held to maturity. For those who invest in TIPS through ETFs or mutual funds, that could mean modest declines from here, but that doesn't mean you need to abandon your holdings. If yields rise and the funds rebalance, investors may be rewarded with higher income payments to help offset some of the potential price declines.