U.S. Treasury Building, Washington, D.C. Image courtesy Wikimedia Commons.

Despite the allure of huge potential gains in the stock market, most investors need to keep at least some of their money in more conservative investments. Yet for years, investment experts have warned that rising interest rates would crush the value of most bonds, causing unexpected losses for bond investors. As fears of inflation rise, though, more investors are looking at a special type of bond known as Treasury Inflation Protected Securities, or TIPS. But do TIPS make sense for your portfolio? Let's look at what makes Treasury Inflation Protected Securities so unusual and see whether they can help you in ways that ordinary bonds can't.

Fighting against inflation with Treasury Inflation Protected Securities

For most bonds, one of the biggest threats is inflation. To buy a typical bond, you pay a fixed amount up front, agreeing to take fixed amounts of interest at various intervals. When the bond matures, you get the original amount of your investment back along with the final interest payment.


Source: U.S. Treasury.

By the time the bond matures, though, inflation has reduced the purchasing power of the money you initially invested. For instance, with a typical $1,000 30-year Treasury bond, you're guaranteed to get the $1,000 in principal back at maturity -- but by the time 30 years has passed, the purchasing power of that $1,000 will have been cut in half, even assuming modest inflation rates of around 2.5%.

The government designed Treasury Inflation Protected Securities to fight the impact of inflation. Rather than giving your original investment back, TIPS have their final payment at maturity adjusted upward to reflect inflation throughout the period. In addition, interest payments rise steadily in line with moves in the Consumer Price Index, which is the government's gauge of inflation for these purposes. As a result, using the same 2.5% inflation assumptions as above, a $1,000 30-year TIPS bond would pay out almost $2,100 at maturity 30 years from now -- equivalent to the purchasing power of $1,000 today.

The pros and cons of Treasury Inflation Protected Securities

Because TIPS are indexed to changes in inflation, the inflationary pressures that affect regular bonds leave TIPS largely unscathed. So when interest rates on regular bonds rise because of inflation, the interest rates on TIPS -- and thus the price of TIPS -- will remain relatively stable.

The Federal Reserve plays a vital role in the bond market. Image source: Dan Smith.

Moreover, from a planning standpoint, using TIPS for future income needs is easier. With regular bonds, you have to worry about the unknown impact of inflation on purchasing power. With TIPS, though, you're assured that the value of the bond at maturity will keep up with inflation.

But there are some trade-offs with Treasury Inflation Protected Securities. The most obvious is that the interest rate you get on TIPS is much lower than on regular bonds. That's because with regular bonds, the interest payments are what compensate you for inflation risk, while TIPS back-load the impact of inflation into the maturity payment. In fact, interest rates on short-term TIPS have been persistently negative in recent years, and even long-term TIPS have seen their rates stuck in a 0% to 1% range for a while now. At the same time, if interest rates on TIPS rise -- which can happen if the bond market anticipates rate increases for reasons other than inflation -- then they can lose principal value as well if not held until maturity.

Also, the way that TIPS get taxed is complicated. Even though you don't receive the inflation adjustment until the bond matures, the IRS forces you to include the rise in value that comes from inflation each and every year in your taxable income. That increases the tax cost of TIPS and makes them most suitable for use in tax-deferred retirement accounts like IRAs.

With fears of inflation starting to rise, Treasury Inflation Protected Securities are getting more attention from investors. Although they won't replace all of your allocation to the bond market, TIPS can be a good way to diversify your bond portfolio from the negative impact of inflation going forward.

Top dividend stocks for the next decade

