The market for U.S. Treasury Inflation-Protected Securities (TIPS) has grown steadily since their introduction in 1997. TIPS are marketable Treasury securities whose principal and interest payments are adjusted for inflation. The U.S. Treasury has issued over US$ 1.9 trillion, as of August 31, 2024.
What are TIPS?
TIPS are designed to protect investors from the risk of higher-than-expected inflation. TIPS will adjust their principal based on changes in the U.S. Consumer Price Index (CPI) and pay out a fixed coupon rate on the principal. As the size of the principal is adjusted, the coupon will also change, increasing and decreasing with changes in the CPI.
Understanding TIPS ETF Income Distributions
TIPS ETFs pay out the earned income of the portfolio which includes the accrued coupon income plus the inflation adjustment less fund expenses (e.g. management fee). This inflation adjustment is based on two months’ prior CPI applied to the fund’s underlying securities. For tax purposes, the principal adjustment is classified as Treasury income and is distributed as cash by the fund even though it is not distributed to individual TIPS holders as cash (known as phantom income for holders of TIPS). If there is deflation, the TIPS ETF might omit or not pay a monthly distribution.
Principal Amounts
Like a nominal U.S. Treasury, TIPS are issued with an original face value of $1,000. To measure inflation, the Treasury uses the CPI-U (Non-Seasonally Adjusted CPI Index for All Urban Consumers) to adjust the principal up or down. At maturity, an investor will receive the greater of the bond’s original principal or the inflation-adjusted principal value.
Coupons
TIPS will pay out a fixed percentage of the principal as its coupon semi-annually until maturity. As the principal is adjusted up or down, the dollar amount of the coupon paid out will vary. When TIPS are issued, their initial coupons are set at the prevailing real interest rate, which is the nominal rate of a similar duration Treasury, adjusted for market assumptions of future inflation. TIPS coupons generally yield less than Treasuries.
Inflation Adjustments
The principal amount of TIPS are adjusted by changes in the CPI-U. This measures the changes in prices paid on a representative basket of goods and services. This metric is published monthly by the Bureau of Labour Statistics.
Breakeven Inflation
The difference between the yield of a nominal bond and an inflation-linked bond of the same maturity. This can be thought of as a market-based measure of inflation expectations, or the level of inflation required for investors to be indifferent (i.e. ‘break even’) between holding the nominal bond and an inflation-linked bond.
Real Yields
Yield of a nominal bond minus the rate of inflation.
- Real Yield = Nominal Yield – Expected Inflation
Phantom Income
When TIPS principal values are adjusted upwards, this change in value is viewed by tax authorities as income paid to the investor and is thus taxable. However, investors do not receive the cash flow from this income until the maturity of the bond, hence the term ‘phantom income’. The ETF pays out the inflation adjustment in monthly income, which provides the cash flow to match the tax consequences.
Conclusion
Just as you might own fixed income to hedge against the possibility of declines in the equity market, investors could consider having at least some allocation to TIPS to hedge against the possibility of higher-than-expected inflation. In addition, TIPS have historically provided investors with diversification benefits, making them a core element to a well-rounded portfolio.
