Treasury inflation-protected securities (TIPS) are popular with bondholders, particularly when the economy isn't performing well. For many investors, TIPS seem like an obvious choice when there is above-average uncertainty about inflation and market returns.

Unfortunately, TIPS do not always live up to their billing, primarily because most people don't understand this investment as well as they should.

Key Takeaways

  • TIPS frequently underperform traditional Treasuries, particularly when deflation becomes an issue.
  • TIPS rely on the CPI, which may understate inflation for potential TIPS investors because these investors tend to be older and less likely to switch to new goods.
  • TIPS are considerably more volatile than cash, especially during stock market crashes.

1. TIPS Often Underperform Traditional Treasuries

In many ways, TIPS are similar to other government securities sold by the U.S. Treasury. As with Treasury bonds, they are backed by the full faith and credit of the United States government and pay annual interest. The crucial difference is the face value of a TIPS bond is adjusted according to the official consumer price index (CPI). The higher the CPI, the higher the face value for the TIPS.

On the surface, this seems like a great deal. After all, inflation eats away at nominal interest payments. With TIPS, an upward adjustment of face value also means that interest payments go up with inflation. TIPS are therefore perceived as safer, which lowers their expected returns because of the risk-return tradeoff. However, TIPS aren't the only securities that price in inflation. Standard Treasury bonds also have an implicit inflation adjustment.

If the markets anticipate inflation to be 3% over time, then that expectation is priced into the bond market. Investors make decisions based in part on whether they think inflation will be higher or lower than what the price of a security reflects. That impacts the value of TIPS and standard Treasury bonds, but TIPS are less likely to win this exchange.

Given this scenario, TIPS will only perform better than Treasury bonds if the stated CPI is higher than what the market anticipates. Several prominent economic theories, including rational expectations and efficient markets, suggest that is unlikely.

On the other hand, TIPS have very real issues during periods of financial stress when traditional Treasury bonds shine. The problem is due to the way the government designed the deflation floor for TIPS. The Treasury guarantees that the principal for TIPS will not fall below the original value.

However, later upward adjustments for inflation can be taken back if deflation occurs. Therefore, newly issued TIPS offer much better protection from deflation than older TIPS with the same time to maturity. When deflation becomes an issue, as it did in 2008 and March 2020, TIPS ETFs, such as the iShares TIPS Bond ETF (TIP), decline significantly.

Exchange traded funds (ETFs) are often the most practical way for investors to buy TIPS.

2. The CPI May Not Reflect Your True Inflation Rate

There are reasons to believe inflation might be higher than official statistics suggest for older and even middle-aged Americans. These are also the groups more likely to buy TIPS. The CPI originally measured a fixed basket of goods. However, consumers often switch to cheaper new goods, making inflation numbers based on a fixed basket of goods too high. The Bureau of Labor Statistics (BLS) revised the CPI to include these substitutions.

Many people tend to become more set in their ways as they grow older, which means they are less likely to switch to new goods. Some of this reluctance is simply logical, as they have less time to recoup investments in learning new ways to do things. It is precisely the retirees seeking to preserve income with TIPS who are least likely to make substitutions, so they end up with higher inflation.

Substitution seems like a subtle effect, but consider how profound it can be. Some retirees looking to TIPS for protection still use landline phones instead of VoIP or smartphones and cable TV rather than streaming video. These costs can add up. Most critically, retirees may continue to live in locations that have become less affordable.

3. TIPS Prices Are Volatile

Some have called TIPS the only risk-free investment because of their principal safety and inflation protection features. However, one of the major indicators of risk is price volatility, and TIPS often come up lacking in this department.

The wild price swings seen in TIPS ETFs during the 2008 and 2020 stock market crashes show they are not nearly as stable as cash in the short run. What is more, TIPS with substantial accumulated inflation factored into their prices could lose a significant amount if a deflationary depression occurred.

The Bottom Line

That is not to say that you should never invest in TIPS. Just be aware of their potential shortcomings. Understanding how TIPS work is the key to using them effectively in your portfolio.