Treasury inflation-protected securities (TIPS) have seen their yields spike since the Federal Reserve warned that interest rates are likely to stay higher for longer – and that can pose an interesting question for bond investors. The yield on the 5-year TIPS was 2.48% on Wednesday afternoon, while the rate on the 10-year TIPS was 2.29%. Rates on both securities are up sharply in the week since the Fed’s policy September meeting, with the yield surging by 6.8% on the 5-year TIPS, and jumping 14% on the 10-year security. TIPS are beloved by retirees because of their ability to provide inflation protection over the long run. The par value of the bonds adjusts with inflation, based on the consumer price index for all urban consumers. At maturity, you receive the greater of the inflation-adjusted price or the original principal. “TIPS act as a sort of insurance in your portfolio,” said Brett Wander, chief investment officer of fixed income strategies at Schwab Asset Management. “We don’t know what the future holds, but we do know the cost of insuring against inflation increases is way less than it was, and to a notable degree.” But whether it’s time to back up the truck on TIPS will depend on your set of circumstances. A bet on inflation One factor to consider is the longer-term outlook for inflation. CPI has been on a cooling trend compared to last year’s spikes. Though the inflation metric gained 0.6% in August – its biggest monthly increase in 2023 — the annual rate was 3.7%. That’s a far cry from the roughly 9% annualized rate in June 2022. “On the one hand, the cost of hedging inflation has gone down, but at the same time the risk of really high inflation has gone down, too,” said Wander. At that, though these instruments may work well as a long-term inflation hedge, they may suffer in the immediate term when inflation soars. For instance, last year, as the Fed kicked off its higher rate regime and inflation climbed, TIPS suffered a sharp decline in prices. The average TIPS fund fell 9.5%, according to Morningstar. US5YTIPS US10YTIP,US30YTIP 1Y line U.S. 5-, 10- and 30-year TIPS yields over the past year “Rates rose across the board last year, and it left people scratching their heads, ‘Why am I losing money even as inflation rises?'” said Bill Ahmuty, head of SPDR ETF fixed income group at State Street Global Advisors. “That’s where people misunderstood the impact of duration on TIPS.” Duration is a measure of a bond’s price sensitivity to changes in interest rates, and as bond prices swooned in 2022, TIPS suffered too. However, if your plan is to commit only a portion of your long-term fixed income holdings to TIPS and be willing to overlook price volatility as rates fluctuate, they may be a good call. “Looking at TIPS generally, their best place is as a long-term inflation hedge,” said Amy Arnott, portfolio strategist for Morningstar Research Services. “They’re not always the perfect inflation hedge in the short term, and they are very sensitive to changes in market interest rates.” Individual securities vs. ETFs Investors can access the TIPS market in different ways. For starters, you can buy them from the federal government via TreasuryDirect . Issues mature in 5, 10 or 30 years, pay interest every six months and you can start with a minimum purchase of $100. Be aware that while there are no state or local taxes on interest, federal taxes apply. Further, if your principal is adjusted higher, you may be subject to taxes on this “phantom income,” so TIPS should be held in tax-deferred accounts. Retirees may ladder TIPS with maturities of up to 30 years, using the proceeds to cover living expenses, Arnott said. “But if you are using a strategy like that, you have to be willing to live with shorter-term volatility and not be tempted to sell if bond prices are down like they were in 2022,” she said. She noted most investors may be better off sticking with the short to medium portion of the yield curve, and not extending beyond the 5- and 10-year mark. For investors who prefer liquidity, there are exchange traded funds that hold TIPS and pay distributions each month. These funds can also offer a range of maturities and thus duration, which can give investors some diversification. But there is a caveat. “If month-over-month CPI declines, then there is the potential that the ETF may omit the dividend for a short period,” said Ahmuty. “You need to be mindful of how that [monthly distribution] moves.”
