Rising inflation poses a significant risk to fixed-income investments such as bonds. Treasury inflation-protected securities (TIPS) can be a good alternative to diversify your portfolio and protect your retirement funds from the risk of rising inflation.
TIPS were introduced by the U.S. Treasury Department as a special type of savings bond designed to protect against higher-than-expected inflation and are offered with terms of 5, 10, and 30 years. A normal bond with a fixed face value loses its purchasing power if the rate of inflation is higher than the amount of its annual return, also called its coupon. In contrast, the face value of a TIPS adjusts to inflation. For example:
Assume you purchase a TIPS with a $1,000 face value and a 3% coupon. If inflation was 10% during the year, the face value of the TIPS would increase by 10% to $1,100. The coupon, based on higher face value, would be $33. So, the interest payments are protected against inflation and you also receive the higher face value when the bond matures, which helps to counteract the effects of inflation.
However, there are some downsides to TIPS. The security against higher-than-expected inflation comes at the cost of a lower coupon compared with equivalent Treasury bonds. That means if you expect inflation to fall or stay the same rather than rise, standard bonds make more sense than TIPS. Second, TIPS have tax consequences. If a TIPS face value adjusts upwards because of high inflation, that adjusted amount has to be reported to the IRS as income. However, you can avoid this by buying TIPS through a mutual fund or within a tax-deferred retirement account.
TIPS can be a good investment, but they can also be complicated. Consider your options before deciding if they are right for you.