Key takeaways
- With traditional bonds, you pay a face amount and earn a fixed interest rate for the bond's life.
- Treasury Inflation-Protected Securities (TIPS) also have fixed interest rates. However, the face amount adjusts based on inflation, which can increase or decrease your interest payments.
- Buying TIPS directly gives you the most control and helps to limit losses compared to buying a TIPS mutual fund or exchange-traded fund.
With inflation rising, many investors are looking for ways to earn a return that keeps up with inflation. While the options may seem limited, one option gaining popularity is Treasury Inflation-Protected Securities.
Here is how this investment works and helps protect your wealth in high inflationary times—plus, how Q.ai can help you do just that.
What are treasury inflation-protected securities?
Treasury Inflation-Protected Securities (TIPS) are U.S. government bonds that pay interest based on the current inflation rate. They're an excellent place to put cash because the federal government backs them.
TIPS also help investors diversify their portfolios, are guaranteed to deliver a return on investment, and have the potential for higher returns compared to savings bonds or other types of Treasuries.
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How do TIPS work?
To understand how TIPS works, it is crucial to know how a regular bond works. When you invest in Treasury Bills, Notes, or Bonds, you buy in increments of $100. They mature in various time frames (from four weeks to 30 years), have a fixed interest rate, and pay semi-annually.
If you were to purchase $1,000 worth of bonds that mature in 20 years and pay 5% interest, you would earn $50 yearly, or $25 every six months, for 20 years. When the bond matures at the end of 20 years, your $1,000 principal is returned to you.
TIPS face value
Investing in TIPS is slightly different because the face value of your investment changes based on inflation.
For example, say you purchased $1,000 worth of TIPS that mature in 20 years and have a 5% interest rate. Additionally, let’s say the inflation rate eventually increases by 5%. At first, you would earn $50 each year or $25 every six months.
However, once the bond is adjusted for inflation, the TIPS principal is now $1,050.
Your 5% interest rate is fixed for the entirety of the bond. But, since the principal amount increased, your interest payments go up because 5% of $1,050 is more than 5% of $1,000.
It is essential to also understand that if deflation is present, the principal of TIPS can decrease below the purchase price.
TIPS interest rates
The principal value of TIPS is based on the current rate of inflation as indicated by the Consumer Price Index (CPI).
The last opening auction for TIPS was held on 10/20/2022, and the interest rate for a five-year security was 1.625%. In comparison, the auction for a five-year Treasury Note on October 31, 2022, had an interest rate of 4.125%.
While the interest rate on the Treasury Note is higher, if you expect inflation to remain high or increase over the next five years, the TIPS investment could pay more because of the adjustments made to the principal.
Selling your TIPS investment early
It is possible to sell your TIPS investment before it matures. However, you may not get the principal you paid if you do so.
Since interest rates for newly issued Treasuries vary, the principal amount of older Treasuries will also differ since there might be more or less demand for it depending on the interest rate.
If your Treasury has a 2% interest rate and new Treasuries have a 6% interest rate, you will have difficulty selling it for face value. Investors would rather pay the same price for a newer Treasury and earn a higher interest rate. As a result, you will have to sell at a lower price.
The opposite is also true. If your Treasury has a 6% interest rate and newly issued Treasuries are paying 2%, you will get more than the principal if you decide to sell it. Again, this scenario only applies if you sell your Treasury before it matures.
How TIPS protect cash during a recession
TIPS allows you to park your cash during a recession and help preserve its value. The face value of TIPS goes up or down with inflation or deflation.
During a non-inflationary time, your investment earns the interest rate offered when purchased. When inflation spikes, the principal on a TIPS increases, which means you'll get a higher rate of interest paid out every six months.
This helps to protect you in the event inflation moves higher. If you were to invest in a Treasury Bond, you would have no protection from higher inflation. The interest payments you earn will be the same every year for the life of the Treasury.
The only way to earn a higher return to potentially keep up with inflation would be to sell your current holdings and purchase new Treasuries with a higher interest rate.
How to buy TIPS
TIPS are sold directly through the government on the TreasuryDirect website. The minimum purchase is $100, and TIPS are available in $100 increments. You can buy them in five, 10, or 30-year terms.
Another option is to purchase TIPS through an exchange-traded fund (ETF) or a mutual fund. Buying TIPS through a fund offers more control over your money since you have more liquidity if you want to sell before maturity, but this option also comes with brokerage fees.
The other thing to consider with purchasing TIPS through a fund is that, most times, the fund will not hold until maturity. Since these investments pool investor money, if some investors want to sell before the TIPS mature, the fund must sell some holdings. Depending on the economic environment, this could result in you losing money.
To have complete control over your investments, your best option regarding TIPS or any bond is to own them directly and not through mutual funds or exchange-traded funds.
The bottom line
TIPS are a smart option to keep up with rising inflation and invest during a recession. With traditional bonds, you are locked into a fixed rate of return for the bond's life. With stocks, you are at the mercy of the overall market.
With TIPS, you’ll get a fixed interest rate with a face value that adjusts based on inflation. This can provide more stability while accounting for the economic climate.
Another solution is to use the Inflation Protection Kit from Q.ai. It uses the power of artificial intelligence to spot trends and invest in assets expected to preserve their value during inflationary times. It's a great alternative that simplifies your investing strategy.
Download Q.ai today for access to AI-powered investment strategies.
