Definition
TIPS, or Treasury Inflation-Protected Securities, are U.S. government bonds whose principal value adjusts with changes in the Consumer Price Index, producing a stream of coupon payments and a final principal payment whose real purchasing power is preserved across the life of the bond.
Why it matters
TIPS are the benchmark instrument for observing what real interest rates the market is pricing at various maturities, and they are the closest available approximation to inflation-protected income denominated in nominal dollars. Their yields sit at the intersection of macroeconomic analysis, inflation expectations, and the pricing of any income arrangement whose real value matters over time.
How it works
TIPS pay a fixed coupon rate on a principal amount that itself moves with the Consumer Price Index. When inflation runs at three percent over a year, a TIPS bond's principal rises by three percent, and the fixed coupon rate is applied to the increased principal, producing higher coupon payments in nominal terms. At maturity, the holder receives the inflation-adjusted principal or the original principal, whichever is greater. Because the cash flows adjust with observed inflation, the yield quoted on a TIPS bond is a real yield, meaning the return the holder receives above and beyond inflation. The difference between the yield on a nominal Treasury bond and the yield on a TIPS bond of the same maturity is the breakeven inflation rate, which reflects the inflation the market is pricing over that maturity.
In practice
For an individual planning retirement income, TIPS are the closest instrument the U.S. market offers for locking in a real income stream without pooling. A ladder of TIPS bonds maturing at each of the years the individual wants income covered will deliver inflation-protected cash flows through that horizon. Ask a professional about a TIPS ladder as a real-income alternative to lifetime income products, particularly for the near-term portion of the retirement horizon, and about the trade-off between the TIPS ladder's certainty and the mortality credit that lifetime income arrangements can produce.
Related terms
- Real interest rate
- Real yield
- Consumer Price Index
- Breakeven inflation rate
- Inflation adjustment
- Real versus nominal returns
- Real versus nominal discount rate
- Duration