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 investment is 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.
- An inflation-protected security (IPS) is a type of bond that guarantees a real rate of return to its investors.
- This means the annual percentage return will fluctuate based on price changes resulting from inflation or other outside factors.
- Most inflation-protected securities invest in debt securities that have a bond principal that fluctuates depending on inflationary pressures.
- The U.S. federal government is the main issuer of inflation-protected securities, including Treasury inflation-protected securities (TIPS) and other inflation-protected bonds.
- However, private sector companies also offer similar products, such as corporate inflation-protected securities (CIPS).
Understanding Inflation-Protected Securities (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 a fixed coupon to a floating one, it can be 100% 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.
Savings vehicles that deliver fixed payouts are particularly vulnerable to the impact of inflation, with higher inflation reducing the value of the payout.
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% during that time frame, an investor’s real rate of return would have been -0.5%. In other words, the investor would have lost money because the investment did not keep up with the rate of inflation.