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TIPS bonds, also known as treasury tips or inflation adjusted bonds, are designed to shield investors from rising prices by adjusting their principal value based on the Consumer Price Index (CPI). But the reality is more nuanced than that. As inflation has cooled from its 9.1% peak in June 2022 to around 3% in January 2025, these inflation protected bonds have behaved in ways many investors didn't anticipate.
I'll dive into whether TIPS truly protect against inflation, how their mechanics work, and what factors actually drive their performance. By examining real-world examples and clearing up common misconceptions, I want to help you decide if these inflation proof investments deserve a place in your portfolio diversification strategy.
Treasury Inflation-Protected Securities (TIPS) represent a unique type of government bond that stands apart from standard Treasury securities. While regular bonds maintain fixed principal amounts, TIPS feature a special mechanism built specifically to tackle inflation risk concerns.
TIPS bonds come from the U.S. Treasury in 5, 10, and 30-year terms with just $100 as the minimum purchase amount. These inflation bonds offer a direct investment in U.S. government debt with built-in inflation protection. At their core, TIPS work like regular Treasury bonds but with a key difference: their principal value changes based on movements in the Consumer Price Index (CPI).
The design is simple – you buy bonds at face value, collect interest payments twice a year, and receive your principal when the bond matures. The real advantage lies in how these elements respond when economic conditions change. Understanding how TIPS bonds work is crucial for investors considering these securities as an inflation hedge.
TIPS principal values rise during inflation and fall during deflation. These face value adjustments happen daily, directly linked to the Consumer Price Index for All Urban Consumers (CPI-U) that the Bureau of Labor Statistics publishes.
For example, if you buy a $1,000 TIPS and inflation increases 3% over a year, your principal grows to $1,030. During deflation, your principal would shrink. However, TIPS include protection against severe deflation – at maturity, you'll get either the inflation-adjusted principal or your original principal amount, whichever is higher. This deflation protection feature ensures you'll never receive less than your initial investment if you hold the bond to maturity.
TIPS pay a fixed coupon rate determined at auction, but the actual payment amount changes because it's calculated based on the adjusted principal. This creates a situation where both your principal and interest payments grow during inflationary periods.
Take this example: with a $1,000 TIPS investment at 0.125% TIPS rates and an inflation Index Ratio of 1.01165, your adjusted principal becomes $1,011.65. The semiannual interest payment would be $0.63 (calculated as $1,011.65 × 0.0625%). As inflation keeps rising, both your principal and subsequent interest payments increase as well, offering true inflation protection that regular bonds simply cannot provide.
This mechanism makes TIPS especially valuable for investors looking to shield themselves from unexpected inflation spikes while maintaining the safety of Treasury-backed securities.
The inflation surge of 2021-2023 revealed surprising behavior from TIPS, showing just how complex the relationship between inflation protection and actual investment returns can be.
When inflation hit a 40-year high of 8.6% in June 2022, many investors naturally expected their inflation-protected securities to deliver strong positive returns. Initially, this expectation proved correct - TIPS fulfilled their purpose when inflation began outpacing forecasts in 2021. As the inflation wave built momentum, TIPS outperformed similar-maturity nominal Treasuries. Looking at the bigger picture, research shows TIPS outpaced inflation in 69% of rolling 12-month periods from 2001 to 2022, demonstrating relative consistency—but not necessarily outperforming all asset classes or producing strong real returns in every period..
But here's the puzzling part: despite rampant inflation, TIPS funds lost nearly 8% in 2022. How could this happen? This counterintuitive result comes from TIPS responding to multiple economic factors at once. While their principal value adjusts upward with inflation, their market prices remain vulnerable to interest rate changes. When the Federal Reserve aggressively hiked rates to fight inflation, these higher yields pushed TIPS prices downward. The result? The downward pressure on prices often overpowered the upward adjustments for inflation.
Real yields (bond yield minus inflation rate) play a crucial role too. When Treasury yields climb because of rising real yields rather than inflation expectations, TIPS become susceptible to losses.
TIPS typically outshine conventional Treasury bonds when actual inflation exceeds what markets expect. During the 2021-2023 period, TIPS did serve their intended purpose by performing better than similar-maturity nominal Treasuries. Though both TIPS and traditional Treasuries suffered losses in 2022 (-11.85% vs. -12.46%), TIPS still offered relatively better protection.
TIPS shine brightest in environments with unexpectedly high inflation but struggle during deflationary periods or when interest rates spike sharply. They may not work perfectly as short-term inflation hedges, but they remain valuable tools for preserving purchasing power over longer timeframes.
Looking at actual examples reveals how TIPS investments perform during real inflation cycles. The gap between theory and practice becomes crystal clear when examining specific securities through complete market cycles.
Let's examine a perfect real-world example - a 5-year TIPS (CUSIP 912828ZJ2) that matured in April 2025. This security was auctioned on April 23, 2020, with a negative real yield of -0.32%. Why would investors accept this negative yield? Because the 5-year nominal Treasury yielded just 0.37%, creating an inflation breakeven rate of merely 0.69%.
This breakeven rate turned out to be remarkably pessimistic. In reality, inflation averaged 4.3% during the bond's lifetime. The result? This TIPS produced a nominal return of around 3.9% through maturity, outperforming the comparable 5-year Treasury by an annual margin of 3.61%.
The performance story shifted dramatically once inflation surged to 4.2% in April 2021 and peaked at 9.1% in June 2022. This case shows how TIPS can deliver effective inflation protection even when starting with negative real yields. It's worth noting that the 10 year TIPS yield often serves as a benchmark for longer-term inflation expectations.
Individual TIPS behave differently from TIPS funds, particularly when held until maturity. Unlike funds, individual TIPS guarantee an inflation-adjusted return if you hold them to maturity. At maturity, you receive either the inflation-adjusted principal or the original principal, whichever is greater.
Consider this example: a 5-year TIPS purchased for $100 with a 1.50% coupon. Through various inflation periods, its adjusted principal eventually grew to $107 by maturity, with interest payments increasing from $15.30 to $16.05. Despite price fluctuations in secondary markets, holding this bond to maturity delivered its full inflation-adjusted value.
The same pattern appears in our CUSIP 912828ZJ2 example. While its secondary market price initially dropped more than its inflation adjustment, the price gradually recovered as it approached maturity. Meanwhile, its inflation-adjusted value continued climbing, ultimately providing complete inflation protection. This demonstrates how individual TIPS can effectively preserve purchasing power when held for their full term.
Many investors hold significant misconceptions about Treasury Inflation-Protected Securities that lead to disappointment when performance doesn't match expectations. Clearing up these misunderstandings is crucial for making smarter TIPS investment decisions.
TIPS are not effective short-term inflation hedges - this is perhaps the most widespread misconception. Many investors who purchased TIPS during the 2021-2023 inflation spike felt betrayed when their investments lost value despite record-high inflation. From December 2021 through November 2024, the Bloomberg US TIPS Index dropped more than 6%. This seemingly contradictory performance happened because TIPS, despite their inflation protection features, are still subject to interest rate risk and market volatility in the short term.
Another common misunderstanding is that TIPS always provide positive returns when inflation is positive. While TIPS do adjust their principal for inflation, their market price can fluctuate based on factors like changes in real interest rates. This means that in the short term, TIPS can experience negative returns even during inflationary periods.
Some investors assume TIPS are as liquid as regular Treasury bonds. While TIPS do have a secondary market, it's generally less liquid than the market for nominal Treasury securities. This can affect the ease of buying and selling TIPS, especially during times of market stress.
For investors interested in adding TIPS to their portfolio, there are several ways to purchase these securities:
When incorporating TIPS into your portfolio, consider your overall investment strategy, risk tolerance, and time horizon. TIPS can play a valuable role in portfolio diversification, particularly for investors concerned about long-term inflation risk.
It's important to understand the tax implications of investing in TIPS. The inflation adjustments to the principal are taxable as interest income in the year they occur, even though you don't receive this money until the bond matures. This can create a tax liability without a corresponding cash flow, a situation known as "phantom income."
Additionally, TIPS interest payments are subject to federal income tax but are exempt from state and local taxes. These tax considerations can affect the overall return of your TIPS investments and should be factored into your investment decisions.
TIPS offer a unique way to protect against inflation risk, but they're not a perfect solution for every investor or every economic scenario. Their effectiveness as an inflation hedge is most apparent over longer time horizons, and they can play a valuable role in portfolio diversification.
Before investing in TIPS, consider your goals, time horizon, and how these bonds complement the rest of your portfolio. It's easy to get caught up in the theory—but what really matters is how TIPS perform within your specific context.
That’s where tools like the 8FIGURES can help. It analyzes your portfolio and gives you AI-driven insights—so you can see whether TIPS, nominal Treasuries, or real assets truly improve your risk-adjusted returns.
Managing your investments has never been easier!
