Financial journalists love Treasury Inflation-Protected Securities.  I do not.  

By J.R. Robinson, Financial Planner (November 2024) 

With fears of a resurgence of inflation mounting, many personal finance thought leaders, are waxing poetically about the virtues of TIPS.  Here is a sampling: 

What to Buy if the Election Has You Worrying About Inflation (Wall St. Journal) 

Inflation-Proof Your Retirement Savings Now (Wall Street Journal) 

Do TIPS Belong In Your Portfolio? (Forbes) 

The pitch is that TIPS, like treasury bills, notes, and bonds, are guaranteed by the full faith and credit of the federal government and the principal of the bond grows each year at the same rate as the cost of living as measured by the Consumer Price Index for urban consumers (CPI-U). Like most other bonds, interest is paid semi-annually on the principal value of the bonds.  Unlike traditional bonds, however, the interest paid is slightly higher from one year to the next pursuant to the CPI adjustments to the TIPS’ principal.  If the CPI-U is 0%, then the TIPS’ principal and interest payments stay the same. (Deflation could cause the principal value of TIPS to be adjusted downward.)   

Thus, for investors who are concerned with the prospect of higher inflation and a volatile stock market, TIPS offer both safety and a guarantee that your principal and interest income will keep pace with the cost of living.  So, what’s not to love? 

Tax on “Phantom Income” 

To use the vernacular, T.I.P.S. in a taxable investment account is a P.I.T.A. As Retirement Researcher Wade Pfau, PhD, CFA eloquently explains,  

“Another reason TIPS are not universally adored is that while they are exempt from state and local taxes (like all treasuries), the inflation adjustments provided for their coupon payments and principal are taxable at the federal level. This tax will need to be paid on an ongoing basis for the inflation adjustments on the accrued principal, even though you won’t see a penny of it until the maturity date. Calculating taxes for this “phantom income” can be especially complex, so many retirees prefer to hold their TIPS in qualified retirement accounts.” 

(I could not have said it any better, so I didn’t. See Links to Professor Pfau’s TIPS commentary at the end of this article.) 

Not Great for Cash Flow Either  

Another problem with TIPS is they typically have much lower coupon rates (stated interest rates) than traditional bonds, so for investors who may choose to purchase bonds or CDs for safety and income, the distribution yields on TIPS are often uninspiring.  Again, I defer to Professor Pfau for greater clarity –  

“Another negative is that TIPS tend to have a higher duration than traditional treasuries because of their lower real coupon rates and because the cash flows received from TIPS will weigh more heavily toward payments with bigger inflation adjustments made closer to the maturity date.” 

The Worst of Both Worlds  

For years one of the most outspoken proponents of TIPS (and outspoken critics of investing in the stock market) was Boston University Professor Zvi Bodie. To borrow from the title of one of Professor Bodie’s video presentations, “The Safest Investment Is TIPS.”  In another video, he goes on to say, “TIPS mutual funds are the best available option in Boston University’s [403(b)] plan.” (Source:  Think Advisor) 

Far be it for me to contradict one of the most esteemed academic minds in finance, but…there’s “theory” and then there is how the world really works.  In fact, my objection to TIPS is that they are neither safe nor do they produce enticing real or nominal returns.  To back up my bluster, here is the year-by-year performance of the Vanguard Inflation-Protected Securities Fund (this fund serves as an excellent proxy for the TIPS marketplace) compared to the Vanguard Index 500 Fund for the past 10 years: 

Now, I understand that comparing the performance of a large-cap U.S. stock fund to a TIPS fund is like comparing apples to oranges, but how is it that the fund that invests in “The Safest Investment” has had four negative return years since 2013, while the “risky” stock fund has had only two? 

It is also worth pointing out that in 2022 and 2023 – the two most recent “high inflation” years – TIPS did not provide positive real or nominal returns.   

Finally, below is Vanguard’s summary of the performance of the TIPS fund since its inception in 2003. Try to curb your enthusiasm. 

Source: https://investor.vanguard.com/investment-products/mutual-funds/profile/vipix#performance-fees 

Conclusion  – “Meh” on TIPS. Keep It Simple With Laddering 

The purpose of this piece has been to provide a perspective on TIPS that runs counter to the flowery image that is often painted around them.  Of course, one could counter that the performance data that was used to illustrate performance was taken from a mutual fund and that an investor could purchase an individual TIPS with no principal risk if held to maturity.  This is true, and I have purchased a few 3 to 5-year TIPS in client portfolios over the years.  They have worked as advertised, but the coupons are so low, and the amount of accrued principal from a few years of inflation investments is so nominal that the client response upon maturity is typically, “Meh.”   

In my opinion, investors who are seeking safety and income for some portion of their savings would do well to keep it simple with individual CDs and Treasuries. Although most people don’t think of them as a tool for keeping pace with inflation, laddering maturities can also be an effective strategy fo doing that. The last few years from 2021 through today offer a good example of how this can work.   

When interest rates are low, as they certainly were in 2021, keep the maturities short or even keep savings in money markets/bank deposits instead.  In the last cycle, when rates on CDs/T-bills rose from close to 0% to 3% in early 2022, I encouraged FPH clients to buy 12-month CDs. As rates rose to 4%, I encouraged clients to spread maturities out as far as 18-24 months.  When yields rose to a little over 5%, I encouraged people to spread maturities out as far as they could to still get 5%, which was 4-5 years.  I advised them to extend as far as 6-7 years if yields at those maturities reached 6%, which they did not.  

By earlier this year, the Fed’s hawkish interest rate hiking policy appeared to have worked, and inflation had declined closer to the Fed’s 2-3% long-term target.  In terms of how laddering helps manage inflation, as interest rates have declined over the past several months, investors who locked in 5% yields are now earning yields above the inflation rate.  

NOTE: At this time, I am once again discouraging FPH clients from purchasing CDs/treasuries and am encouraging them to allocate cash from maturing CDs and treasuries to treasury money market funds instead. I believe the ultra-low interest rates of the 2010s-2021 were a generational anomaly and do not believe rates will retreat to anywhere near the 2021 levels.  I believe there is a better-than-average chance that inflation may return in a big way in the next few years and that laddering will be back on the menu at that time. 

Readers who would like further unvarnished portfolio management content may wish to check out my latest post, “My Two Cents—Irreverent Commentary on the Stock Market, Interest Rates, Income Investing, and Disaster Hedging.“ 

RELATED READING 

The TIPS You May Need – Part 1 (Retirement Researcher/Wade Pfau) 

The Tips You May Need – Part 2 (Retirement Researcher/Wade Pfau) 

John H. Robinson is the owner/founder of Financial Planning Hawaii and Fee-Only Planning Hawaii. He is also a co-founder of fintech software maker Nest Egg Guru and the new personal finance website NestEggPF.com.