Everything investors need to know about TIPS

Investors looking for a way to hedge against inflation are increasingly turning to TIPS, or Treasury Inflation-Protected Securities.

A common belief is that by the time you hear about TIPS, like when they hit the headlines and rack up new assets, it’s too late for the party. However, the massive inflows into the FlexShares iBoxx 3 Year Target Duration TIPS Index Fund (TDTT) tell a different story.

TDTT had $109 million in net inflows over a four-week period and $668 million in net inflows year-to-date, according to ETF Database.

TIPS are securities issued by the US Treasury that are designed to provide inflation protection to investors. TIPS are income-generating instruments whose interest and principal payments are adjusted for inflation, making them very attractive in the current environment.

Assets in TIPS funds have jumped and have now nearly doubled since 2018 to around $295 billion in February, according to the Wall Street Journal.

TIPS-focused ETFs and mutual funds outperformed other bond funds last year for the second year in a row, with 2021 posting total returns of 5.5% on average, compared to -1.7% for a fund US bond index, according to Morningstar, suggesting that investors may be looking for performance in their decisions to allocate to TIPS.

Most bonds pay investors a fixed amount of interest semi-annually, then pay the original face value of the bond at maturity; TIPS, however, are tradable securities whose principal is adjusted for changes in the consumer price index.

The principal of a TIPS increases with inflation and decreases with deflation, as measured by the CPI. The relationship between TIPS and IPC affects both the amount an investor is paid when their TIPS matures, as well as the amount of interest paid by a TIPS.

TIPS pay interest twice a year at a fixed rate. The rate is applied to the adjusted principal, so interest payments may vary in amount from period to period. As inflation increases, interest payments increase. In case of deflation, the interest payment decreases.

TIPS are issued in terms of five years, 10 years and 30 years. At maturity, an investor receives either the adjusted principal or the original principal, whichever is greater, protecting investors against deflation.

A significant disadvantage of owning individual TIPS as an investor is the complexity of tax consequences. Even though holders will not see any growth in the face value of TIPS until the security matures or the investor sells, holders must pay federal taxes on any gain in face value.

Investors can avoid this tax implication by investing through pooled investment vehicles, including tax-efficient ETFs such as TDTT and the FlexShares iBoxx 5-Year Target Duration TIPS Index Fund (TDTF).

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