With inflation remaining “stubbornly high”[1] we today take a look at the usefulness, or lack thereof, of TIPS.
Please don’t buy TIPS without reading this.
TIPS stands for Treasury Inflation-Protected Bonds.
The US Treasury describes TIPS thus (we added the “bold” fond for emphasis):
Treasury Inflation-Protected Securities (TIPS) are marketable securities whose principal is adjusted by changes in the Consumer Price Index. With inflation (a rise in the index), the principal increases. With a deflation (a drop in the index), the principal decreases.
The relationship between TIPS and the Consumer Price Index affects both the sum you are paid when your TIPS matures and the amount of interest that a TIPS pays you every six months. TIPS pay interest at a fixed rate. Because the rate is applied to the adjusted principal, however, interest payments can vary in amount from one period to the next. If inflation occurs, the interest payment increases. In the event of deflation, the interest payment decreases.
At the maturity of a TIPS, you receive the adjusted principal or the original principal, whichever is greater. This provision protects you against deflation.
The Inflation Adjustment is Made Annually to Principal
TIPS are complex, much more complex than standard bonds. So the following analysis is somewhat simplified.
To a first approximation, the principal (i.e. the face value) of a TIPS bond is adjusted each year by the change in the CPI. For example, if the TIPS bond started a year with a principal amount of $100, and the CPI for the year were 2%, the TIPS principal would be adjusted at year end to $102. The adjusted principal is paid only upon maturity.
We wrote the following back in 2021:
TIPS were introduced in the US in 1997. Official inflation has remained quite low from then until this writing in April, 2021. As a consequence, there is little useful historical evidence to tell us how TIPS have actually performed for real investors in time of high inflation.
However, there are several reasons TIPS may disappoint, even in times of higher inflation. Two of these reasons are technical, related to the fact that the TIPS adjust according to changes in the Consumer Price Index. First, as earlier discussed, for any given investor, the Consumer Price Index may or may not be a particularly good fit. A second reason, discussed at length in Chapter XX, is that the Consumer Price Index may systematically understate inflation.
A less discussed reason TIPS may disappoint is buried in the technicalities of how TIPS are taxed.
Federal Taxes – The Phantom Income Risk
TIPs may involve complex or surprising tax results. TIPS pay interest, and that interest is subject to federal income tax (but as with other Treasury interest, not to state or municipal income taxes). But TIPS may also generate taxable income without any accompanying cash.
When CPI inflation is positive (i.e. greater than zero) for a year, at the end of the year the treasury will adjust the principal value of the TIPS bond. This adjustment is taxable income for that year. If you own the TIPS bond in a taxable account (e.g. not an IRA), the TIPS bond will generate so-called phantom income.[2] For example, suppose you owned $100,000 principal value of TIPS at the beginning of the year, and CPI inflation were 2%. The 2% adjustment would result in your being credited with $2000 of taxable income, despite the fact that you received no cash.
It seems not much is actually known about how investors view the phantom income risk. Few writers seem to mention it; some who do advise that TIPS should only be owned in tax-exempt accounts such as IRAs. But even this advice may miss a “hidden” systematic risk to TIPS in times of high inflation.
Because there have not been periods of high CPI inflation since 1997, TIPS have not had years when they had a large principal adjustment. The scant evidence available suggests that the marginal TIPS buyer ignores the different tax treatment of TIPS relative to regular treasuries.[3] We can only guess at what might be the market reaction to discovering that the investment they thought was an inflation hedge turned out instead to be an inflation tax.
For example, consider the previous example of $100,000 principal value of TIPS at the beginning of the year. If inflation were 11.1% for the year (as it was in 1974), the owner would be hit with an unplanned $11,100 of extra taxable income, without any cash to pay the extra tax. Or if inflation hit 1980’s 13.5%, the extra taxable income would be $13,500. For bonds issued at the low rates prevailing in 2021, single year’s phantom income could wipe out a decade’s worth of interest. That may not sit well with investors who thought they were buying protection.
It is not hard at all to imagine that at least some investors, feeling burned once they realize what has happened, will dump TIPs, “value” be damned. And so it’s not that hard to imagine that high inflation produces on TIPS almost the opposite effect from the widely expected inflation hedge which is hoped for by buyers today.[4]
We Were Right
We turned out to be right.
When inflation spiked, TIPS crashed.
The graph shows the last five years, and compares the Consumer Price Index (shown in blue) to the market price of the iShares TIPS Bond exchange traded fund, ticker symbol TIP. Between May 2020 and April 2024, inflation has averaged about 5.1% per year.
Over that same period, TIP has return just about ½% per year.
That’s not a good hedge.
Long an Option – and You Pay For It
As if that’s not enough, there is an option buried in TIPS that, in times of low inflation has significant value. And furthermore, because that option belongs to the buyer, the buyer pays for it. The option is the option to “put” the bond back to the treasury at maturity at the original face value, even if deflation has reduced that value below par.
But almost no one buys TIPS because they want deflation protection. Nevertheless, particularly when inflation is low (and therefore in a statistical, options-pricing-world sense at least, deflation is reasonably probable) the TIPS buyer pays a material price for the option.[5]
Widespread Misunderstanding?
TIPS are promoted by many people as safe inflation protection. For example, it is not uncommon to see a sentiment such as: “TIPS are low risk investments because they’re treasury bonds, backed by the U.S. government.”[6]
Our concern is primarily that TIPS are actually quite complex financial instruments, and for the reasons discussed above, we believe there is a considerable act of faith required to believe that TIPS will actually offer the protection from inflation that most people who buy them expect.
If you found this useful or interesting, please contact Katherine at [email protected], or call 703 437 9720.
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[1] https://www.nytimes.com/2024/04/26/business/inflation-fed-rates.html
[2] This income will be reported as original issue discount (“OID”) and you will receive a form 1099-OID for the amount.
[3] Pricing Treasury Inflation Protected Securities, Joshua C. Fairbanks, Ph.D. dissertation, Texas Tech, 2012.
[4] Excerpted from Politicians Spend, We Pay, Roger D. Silk,
[5] See The Information Content of the Embedded Deflation Option in TIPS, Olesya Grishchenko, et. al., Finance and Economics Discussion Series, Federal Reserve Board, Washington, DC., Paper 2011-58
[6] https://www.thebalance.com/the-benefits-and-risks-of-tips-2466779
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