TIPS and Inflation: What to Know Now

Inflation has proven to be a bit stickier than initially expected, and there are concerns that policy proposals from the incoming Trump administration—like tariffs, tax cuts, and immigration changes—could be inflationary, as well. 

Treasury Inflation-Protected Securities, or TIPS, can help protect against inflation since their principal values are indexed to the Consumer Price Index (CPI). When considering TIPS, however, it's important to understand their unique characteristics and complex nature. In this article, we'll cover TIPS' key characteristics, and then focus on three key considerations for investors today:

• Positive "real" yields
• Breakeven rates that are below the current level of inflation, and
• Why TIPS can protect against inflation over the long run, but shouldn't be considered a short-term inflation "hedge."

TIPS are a type of Treasury security whose principal value is indexed to inflation. When inflation rises, the TIPS' principal value is adjusted up. If there's deflation, then the principal value is adjusted lower. Like traditional Treasuries, TIPS are backed by the full faith and credit of the U.S. government.

The coupon payments are based on a percent of the adjusted principal, so investors can benefit from higher income payments when inflation is rising, as well.

At maturity, however, a TIPS investor would receive either the adjusted principal or the original principal value at issuance. In other words, TIPS won't pay back less than their initial principal value at maturity. 

The table below illustrates how the principal value and coupon payments would rise if inflation averaged 3% every year for a hypothetical five-year TIPS. While the initial principal value is $1,000, after one year that principal value would grow to $1,030. The investor would still earn a coupon payment based on the 2.0% coupon rate, but because the principal value would have risen, the coupon payment would be $20.60 at the end of year one. By maturity, the principal value would rise to $1,159 if inflation continued to average 3% per year.

Here are three considerations for those considering TIPS today:

1. Relatively high yields. Like most bond yields, TIPS yields have risen sharply over the last few years and are still near the high end of their 20-year range. More importantly, TIPS yields are positive, meaning investors who hold individual TIPS to maturity can earn a positive inflation-adjusted yield regardless of the inflation rate.

TIPS yields are "real" yields, already accounting for inflation. The annual rate of inflation over the life of a TIPS ultimately would be added to the stated yield when held to maturity to come up with the annualized "nominal" return. If inflation were to average 3% for the next five years, for example, that 3% inflation rate would get added to the roughly 1.9% "real" yield that a five-year TIPS offers today, resulting in a nominal return of 4.9% annually. The higher (or lower) inflation comes in, the higher (or lower) that nominal total return would be. 

Here's another way to think about TIPS yields: If held to maturity, TIPS should outperform inflation on an annualized basis by a magnitude of that yield. That can be an important concept for investors who are worried that inflation will remain very elevated over the short run or if it were to reaccelerate down the road.

The chart below focuses on five-year TIPS, but yields for most other maturities are near the high end of their 20-year ranges as well. The two- and 10-year TIPS yields were 1.7% and 2.1%, respectively, in mid-November. 

"Real" yields initially rose as the Fed raised its benchmark interest rate to try to cool inflation. High real interest rates make it more attractive for consumers to save than spend, and more difficult for businesses to borrow, hire, and invest. But high real yields can present investors an opportunity to beat inflation going forward.

2. Breakeven rates. The difference between TIPS yields and yields offered by traditional Treasuries is important to consider when evaluating TIPS. That difference is known as the "breakeven inflation rate." It can be considered a hurdle rate when trying to determine if a TIPS or a traditional Treasury will outperform the other given an expected inflation rate.

The breakeven rate is the rate that inflation, as measured by the Consumer Price Index (CPI), would need to average over the life of the TIPS for it to outperform a traditional Treasury security. If the CPI averaged more than that breakeven rate, investors would have been better off in a TIPS; if it were below, a traditional Treasury would have made more sense.

The five-year breakeven rate is shown in the chart below. At 2.4%, inflation would need to average 2.4% or more over the next five years for a five-year TIPS to outperform a nominal Treasury. That's still below the current rate of inflation, and the recent disinflationary trend in the headline CPI appears to have stalled. The year/year change in headline CPI dropped to 2.4% in September 2024, only to tick back up to 2.6% in October, and the year/year change in core CPI remains stuck above 3%. The 2.4% breakeven rate is currently at the high end of the 14-year range but it's below the current inflation rate.

3. Principal values have adjusted higher, despite negative total returns. TIPS total returns—when measured by TIPS indexes—likely disappointed many investors over the past few years. Despite inflation rates at multi-decade highs, TIPS prices fell sharply in 2022 and 2023.

What happened? TIPS, despite their unique characteristics, are still bonds and subject to the inverse relationship between their prices and yields. When yields rise, prices fall, and vice versa. Over the last few years, the prices of many TIPS have fallen more than the principal value has adjusted higher, resulting in negative total returns. From December 31, 2021 through November 15, 2024, the Bloomberg US TIPS Index has lost more than 6%. That's likely not the performance investors were expecting given how high inflation rose, but the large price declines more than offset the rise in principal values due to the inflation adjustments. This is a key reason why TIPS can protect against inflation over the long run but shouldn't be considered an inflation "hedge" over the short run.

Those negative returns aren't indicative of the whole TIPS market, especially individual TIPS. Price fluctuations in the secondary market are temporary as long as you hold to maturity. TIPS prices have generally fallen over the last two years, but the principal values have risen. Consider this TIPS that was issued in October 2020, maturing in October 2025: Its inflation-adjusted value has risen to over $1,200 since it was issued, or a more than 20% increase.

Although prices fell sharply when TIPS yields rose, looking at the secondary market price doesn't tell the whole story since it doesn't include the inflation adjustment. The chart below illustrates this phenomenon. The blue line represents the price of this TIPS in the secondary market; the red line multiplies that price by the TIPS' inflation index ratio. Initially prices had declined more than the inflation adjustment. Since late 2022, the average price of this TIPS has held relatively steady—and has been gradually rising toward $100 as it approaches its maturity next October—allowing the inflation-adjusted price to rise. This chart, and the chart above, illustrates how holding individual TIPS to maturity can help protect against inflation surges.

There are pros and cons to both holding individual TIPS or investing through a mutual fund or exchange-traded fund (ETF). One benefit that individual bonds offer—when holding bonds to maturity—is the ability to "look through" price declines in the secondary market, knowing the bonds will mature at their par value.

Consider once again the TIPS example shown above—it was issued in October 2020 and its inflation-adjusted price is up over 11% since it was issued, and that doesn't consider the semiannual interest payments. Over the same time frame, the Bloomberg US TIPS Index has gained just 1.5%.

With inflation proving sticky and the potential for inflation to remain a concern given proposed policies from the upcoming administration, TIPS appear attractive. Real yields are still near 2%, and breakeven rates seem a bit low given the current "stickiness" of inflation and concerns it could remain elevated. Investors can earn higher income today with TIPS than they generally could have earned for the 10-year period leading up to the pandemic, while also helping to protect against inflation over the long-run.

For individual TIPS holders, any potential price declines might not matter if they're held to maturity. For investors who invest in TIPS through ETFs or mutual funds, the value of the funds can fluctuate, but that doesn't mean you need to abandon your holdings. If yields rise further and the funds rebalance, investors may be rewarded with higher income payments to help offset potential price declines, while additional inflation increases would result in positive principal adjustments to the underlying holdings.