According to the latest Consumer Price Index data, inflation is up 0.3 percent for September and 5.3 percent over the last 12 months. Driven by price increases across the board, Americans are struggling to maintain purchasing power. The cost of living continues to rise higher than many companies' minimum wages. TIPS (Treasury Inflation-Protected Securities) can help investors sustain value.
Is now the time for TIPS—or should other, more lucrative investments take precedence for investors trying to maximize their capital?
What are TIPS?
The U.S. Treasury issues TIPS, a type of bond whose value is flexible. That value follows the CPI (Consumer Price Index), which tracks the rate of inflation in the U.S.
As inflation increases, the principal (the price you purchased the bond at) goes up. As deflation occurs, the principal goes down.
How TIPS provide returns for investors
Investors usually earn money from bonds by yielding interest and that's the case with TIPS.
TIPS pay interest to investors twice per year at a fixed rate. These interest payouts are called coupon payments.
While the payout comes in the form of a fixed rate, the bond's principal is always changing, which means that the coupon payment is changing right along with it. In theory, more inflation means a higher principal, which means that the fixed rate provides a higher payout on the TIPS.
What to expect when cashing out on TIPS
Because they're a type of bond, TIPS have a bond term. Once that term ends, you've hit your maturity date. That's when you get to sell the bond. At this point, you have already received coupon payments twice yearly on the bond, and can sell the bond for the greater of two options:
The bond's principal (similar to the cost basis of a stock, it's what you originally paid for the bond)
The inflation-adjusted principal
This is a lot different than regular bonds, which just pay the principal regardless of inflation. Since TIPS is based on inflation, investors get a cool perk when it comes time for returns.
What are the risks of investing in TIPS?
Since the U.S. is currently in a period of high inflation, it can feel like a no-brainer to invest in tips. After all, inflation is currently much higher than federal interest rates, and low Fed rates means low yields in high-yield savings accounts. It also means that money in those savings accounts is actually decreasing in purchasing power as the months go on.
However, TIPS don't always follow inflation to a tee. This is because TIPS follow a "real yield," which combines inflation rates with the overall purchasing of TIPS. As investors and the Federal Reserve have piled onto TIPS over the last year, TIPS have become more expensive.
Because of this, a current 30-year TIPS has a real yield of -0.28 percent. Thanks to Fed Chair Jerome Powell projecting that the government will taper its bond purchases, the value could increase.
Should you use TIPS to hedge against inflation right now?
September has been a tough month for the stock market. Meanwhile, federal interest rates (and savings yields) remain low. Inflation is on the up-and-up and markets like used cars and gas are taking a toll on the poor to middle class.
Theoretically, TIPS can hedge against inflation, but such high demand poses the question: Is it worth it?
TIPS real yields could return to the green as Fed tapering starts. Just remember that the Fed tends to take things like tapering slowly, so don't be surprised if those yields rise slowly, too.