TIPS Explained: Inflation-Protected Treasury Bonds

Buy a TIPS and you are lending in units of purchasing power. The number of dollars you are owed moves. What those dollars are meant to buy holds still, which is the whole design, and it explains why the yield quoted on the security looks so thin beside an ordinary Treasury note maturing on the same day.

Most of the confusion around these bonds starts with reading that thin number as the return. It is a return above something, and the something has to be named before the number means anything.

The index ratio does all the moving

Two figures determine what the Treasury owes you on any given day. One is the par amount on the security, which never changes. The other is the index ratio.

The Treasury builds a reference CPI for every calendar day by taking the published consumer price index for all urban consumers from three months earlier and interpolating across the days of the month, so the reference figure for the first of September is the index published for June, and each day after the first steps smoothly toward the July figure that governs the first of October. The index ratio is that day’s reference CPI divided by the reference CPI on the day the security was first dated. Multiply par by the ratio and you have the inflation-adjusted principal.

The three month lag is no rounding detail. What you are credited with this month describes prices measured a quarter of a year ago, which is invisible when inflation drifts and very loud when it turns. The index doing the work is the same constructed, revised, nationally averaged number described in inflation and CPI explained, carrying all of the same limits.

Five years, worked out

Take $10,000 of par with a 2% coupon rate. Assume for legibility that each year’s adjustment lands in one go on the anniversary, when in reality it accrues daily.

Year	CPI change	Index ratio	Adjusted principal	Annual coupon at 2%
At issue		1.0000	$10,000.00	$200.00
1	4%	1.0400	$10,400.00	$208.00
2	2%	1.0608	$10,608.00	$212.16
3	3%	1.0926	$10,926.24	$218.52
4	-1%	1.0817	$10,816.98	$216.34
5	2%	1.1033	$11,033.32	$220.67

The coupon rate never moves. The dollars it produces move every year, because 2% is being applied to a principal that is itself climbing, and the payment arrives in two equal halves six months apart exactly as on any other Treasury note. Add the five coupon rows and the income comes to $1,075.69. At maturity the Treasury repays $11,033.32.

Year four is the row worth staring at. Prices fell 1%, the principal fell with them, and the coupon fell too, from $218.52 to $216.34. Nothing floors the payments along the way.

A nominal note issued the same week would have carried a higher coupon, so the table on its own proves nothing about which security was the better buy. That comparison needs one more number.

Real yield, and the breakeven that connects two markets

Every nominal Treasury yield contains compensation for expected inflation, buried inside it, never itemised. A TIPS yield has that piece removed by construction, since the compensation is being delivered through the principal. What remains is a real yield.

Suppose a ten-year note yields 4.00% and a ten-year TIPS yields 1.50%. The rough breakeven is the difference, 2.50%. The exact version accounts for the compounding:

(1 + 0.0400) / (1 + 0.0150) - 1 = 0.0246

So 2.46% a year is the inflation rate at which the two securities finish level. Run inflation above it and the TIPS holder wins. Run it below and the nominal buyer does. Both of them have taken a position on inflation, and only one of them has taken it deliberately.

Real yields can go negative, and when they do, a TIPS held to maturity guarantees a loss of purchasing power. That is still information worth having. A negative real yield tells you what the safest inflation-linked asset in the world is being priced at, and every other real return in the economy is quoted against that benchmark whether the quoting party says so or not.

Two risks live inside a nominal bond

A nominal Treasury exposes the lender to two separate things. One is the real rate of interest the market demands for parting with money. The other is inflation, both the amount expected on the day the bond was priced and the amount that eventually shows up. A TIPS removes the second and leaves the first completely intact.

So a long-dated TIPS remains a volatile security. Thirty years of real-yield duration is thirty years of duration, a one point rise in real yields does to a thirty-year TIPS roughly what a one point rise in nominal yields does to a thirty-year note, and this is the part almost nobody works through before reaching for the longest maturity on the list because the word protection appears on it. Short maturities behave differently. A five-year TIPS has little duration to lose, tracks realised inflation closely, and swings far less when real yields move, which is the version that behaves the way the brochure describes.

The purchase decision then follows from the breakeven. When it is low, inflation protection is cheap, and the nominal note needs a benign path to pay off. When it is high, the TIPS buyer is paying in advance for inflation that has to arrive on schedule to justify the price. Both positions carry risk. Only the price tells you which one is currently the awkward side of the trade.

The floor at maturity, and what sits above it

At maturity the Treasury pays the adjusted principal or the original par, whichever is larger. A decade of falling prices cannot return less than the $10,000 you lent.

The guarantee has an edge, and buyers of seasoned securities walk over it regularly. Picture a TIPS issued years ago whose index ratio has climbed to 1.2500, so that $10,000 of par now carries $12,500 of adjusted principal, and you buy it in the secondary market paying for every dollar of that accrued inflation. The floor still sits at $10,000. All $2,500 above par is exposed to deflation in a way a newly issued bond is not, which is why the protection is worth most on paper bought close to issue and worth steadily less as the ratio climbs.

Phantom income, and the account it belongs in

The increase in principal is taxable federal income in the year it accrues. No cash arrives. The Internal Revenue Service treats the adjustment as original issue discount, the broker reports it, and you owe tax on money you will not touch for years.

Put numbers on year three of the table. Principal rose from $10,608.00 to $10,926.24, an accrual of $318.24, and the coupon paid $218.52 in cash, so taxable income for the year comes to $536.76 against cash received of $218.52. At a 32% marginal federal rate the bill is $536.76 x 0.32 = $171.76. The coupon covers it with $46.76 left over.

Now raise inflation. At 8% the accrual alone runs past $800 while the coupon barely moves, the tax owed exceeds every dollar of cash the bond produced that year, and the shortfall has to be funded by selling something else, which is precisely the year in which you would least want to be a forced seller of anything. A year of deflation works in reverse and offsets other interest income.

Individual securities against the funds

A TIPS fund holds a rolling basket and never matures, so what you own is a standing exposure to real yields. When real yields rise the fund falls by roughly its duration times the move, on the same arithmetic set out in duration and interest rate risk, and a long-dated TIPS fund carries a great deal of duration. Investors who bought inflation protection and then watched the fund fall during a burst of inflation had met that arithmetic without being introduced to it. Real yields rose faster than the index credited them.

An individual TIPS held to its maturity date settles the question. You receive the real yield you bought, whatever the price did along the way, and the purchasing power of the proceeds is fixed in advance. That is the version worth owning against a known future expense.

The fund earns its keep in a taxable account. It distributes the inflation accrual as cash, so the tax arrives alongside the money to pay it, which turns the worst feature of the individual security into a solved problem. Target-maturity TIPS funds sit in the middle, holding securities that all come due in one year and then winding down. What an ordinary fund gives away is covered in bond ETFs explained.

Where the protection stops

The market for TIPS is smaller and thinner than the market for nominal Treasuries. In a scramble for cash, thin markets get sold first. Breakevens have collapsed during episodes of genuine panic while nothing at all was happening to the inflation outlook, which means the instrument bought as inflation insurance can fall hard in the same week inflation fear is at its loudest, and it does recover afterwards, and the recovery is no comfort to anyone who had to sell during the week in question.

The second limit is the index. CPI averages a national basket that nobody buys. A household whose spending is concentrated in medical care, tuition or rent in one expensive city can hold a security that tracks the national index perfectly and still lose ground every year.

Price the real return on anything you already own with the real return calculator, then set these securities beside the bills, notes and bonds they share an auction calendar with in the Treasury securities guide.