Sometimes, an investment that sounds good in theory doesn’t work out that well in reality. This could be the scenario unfolding for Treasury Inflation Protected Securities—commonly known as TIPS. The bonds’ popularity, combined with today’s prevailing interest rates, could leave investors disappointed by an extremely low rate of return, or even a negative one.
TIPS, which have been around since 1997, are a special kind of U.S. Treasury bond. Like other Treasuries, TIPS pay interest at a fixed rate until they mature. But there’s a twist. TIPS’ principal is adjusted monthly based on changes in the Consumer Price Index (CPI). That provides some protection from future inflation.
TIPS pay interest twice a year, with payments taking into account the CPI adjustments. At maturity, the government pays back the original principal or the adjusted amount, whichever is greater. In other words, investors are promised that TIPS will keep up with inflation and thereby provide a real (after inflation) rate of return.
That concept has proven very popular with investors. The U.S. Treasury says that the amount of TIPS currently in circulation has increased 50% in five years to $850 billion. But with popularity has come higher prices—and very low yields.
Generally, TIPS are thought to be most advantageous when they offer a real return of 2% or more a year. That is comparable to the average historical return, after inflation, of regular bonds. However, as of February 1, 2013, TIPS provided a real return after the inflation adjustment of only 0.5% a year. For TIPS maturing within the next 10 years, the real return is negative, leaving investors worse off than when they started. For example, those buying five-year TIPS were locking in an interest rate of inflation minus 1.4% a year. Over the life of the bond, that would add up to a loss of 7% in real terms.
That situation doesn’t mean you should jettison all of your TIPS immediately. Instead, one possibility is that you might sell off long-term TIPS and continue to hold short-term ones. That could help you lock in your biggest gains now and reduce the odds of being stuck with losses years down the road.
Investors have been gobbling up TIPS in recent years for two main reasons: Some are looking for a short-term alternative to cash, while others are searching for long-term protection against the risk of a sudden rise in inflation, which some economists have predicted. But if significant inflation doesn’t materialize, owning long-term TIPS could be a losing proposition. There may well be better ways to hedge your portfolio against inflation while also earning positive returns.