What Is an Inflation-Protected Security (IPS)
An inflation-protected security (IPS) is a type of fixed-income investment that guarantees a real rate of return. This means the annual percentage return realized on an investment, adjusted for changes in prices due to inflation or other external effects. Expressing rates of return in real values rather than in non-inflation-adjusted terms, especially during periods of high inflation, offers a clearer picture of an investment's value.
Understanding Inflation-Protected Security (IPS)
Inflation-protected bonds primarily invest in debt securities whose bond principal varies depending on the rate of inflation. The purpose of inflation-indexed investments is to protect an investment’s principal and income stream from the corrosive power of inflation.
The U.S. federal government is currently the leading issuer of these types of securities, primarily in the form of Treasury inflation-protected securities (TIPS) and Series I savings bonds. However, private sector companies also offer these inflation-protected products. One example is corporate inflation-protected securities (CIPS), also referred to as inflation-linked bonds. CIPS are the corporate cousin of TIPS. With the corporate version, the coupon can have a ceiling or not; it can go from fixed coupon to a floating one, it can be 100 percent floating and any variation thereof.
All government inflation-indexed securities are benchmarked against the Consumer Price Index (CPI). The CPI measures the prices that consumers pay for frequently purchased items in such industries as transportation, food, and medical care. A sustained increase in the CPI generally indicates that inflation is rising and a dollar’s purchasing power is falling.
Protecting Fixed Payouts from Inflation
If a savings vehicle is delivering a fixed payout, such as a pension or Social Security, inflation can reduce the value of that payout accordingly. Another example is certificates of deposit (CDs), which investors often use to safely tend to their money and avoid the ups and downs of higher-risk assets, such as stock and bonds. However, for long-term investors, CDs may present a different type of risk that can be just as harmful as market risk – the risk of inflation. If the return on an investment does not at least keep up with the rate of inflation, it will result in the loss of purchasing power over the long term.
To illustrate, if a 5-year CD yielded percent, but inflation grew by an average of 2.5 percent during that time frame, an investor’s real rate of return would have been -0.5 percent. In other words, the investor would have lost money because the investment did not keep up with the rate of inflation.