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TIPS may or may not fit into your overall financial plan.
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If rising interest rates have thrown you for a loop, you may be looking for a safe place to protect your cash. If so, Treasury Inflation Protected Securities (TIPS) are worth considering. However, before you do anything, make sure you understand the good, bad, and ugly features that come along with investing in TIPS.
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1. Understand how TIPS work
TIPS are a type of Treasury security. Unlike other securities, though, the principal is not fixed. That means the principal can rise or fall over time. Still, because they’re backed by the federal government, TIPS are considered a safe haven for investors looking to protect money from inflation.
The interest rate on TIPS is set every six months until they mature in 5, 10, or 30 years. Adjustments in interest rates are based on a version of the Consumer Price Index provided by the Bureau of Labor Statistics. TIPS can be held until maturity or sold before that time.
When TIPS mature, if the principal is higher than the amount you originally invested, you receive the higher amount. If it’s equal to or lower than your initial investment, you receive your initial investment back.
2. Familiarize yourself with the pros and cons
Like all investments, TIPS carry both attractive and less-attractive features.
Pros
Because they’re backed by the U.S. government, TIPS are a low-risk investment.TIPS protect investors from losing their money. They may not earn much, but they won’t lose value.TIPS help individuals on a fixed income protect their purchasing power.
Cons
TIPS almost always pay a lower interest rate than other securities.Interest earned on TIPS is taxable, even though the investor does not know how their investment performed until maturity.TIPS do not provide real income like an annuity or other investment can.Even financial experts have trouble determining why the real yield on TIPS move.
3. They may hedge against inflation, but TIPS are moody financial instruments
Due to the fluctuation in interest rates, TIPS returns are notoriously unstable. For example, according to Morningstar, intermediate-term TIPS dropped 12% in 2022.
That’s not always the story, though. TIPS have occasionally represented a more compelling investment option than their Treasury competitors. It’s that “will they or won’t they” that make TIPS somewhat erratic.
4. The 2022 drop may represent opportunity
Despite the ups and downs of TIPS, you always know that you’re going to walk away with — at the very least — your original investment while also keeping pace with inflation. You may not outrun inflation, but it won’t steamroll you either.
While a 12% drop in 2022 sounds scarier than showing up to a wedding in your underwear, the drop means you can park your cash in a TIPS bond at a cheaper price. While others are running out the door, you can sneak in and land a bargain. As Warren Buffett says, we should “be greedy only when others are fearful.”
To be sure, there are sexier investments out there, but few that protect you from the very real concern of inflation. This is one quality that TIPS have going for them.
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