How to use TIPS in your portfolio

Treasury Inflation-Protected Securities were introduced in 1997 to provide inflation-protected interest and principal payments. Unlike other bonds, which generate returns in nominal terms, TIPS act as a direct  hedge against inflation.

TIPS Explained

TIPS are bonds issued by the US Treasury with maturities of five, 10, or 30 years. They pay a fixed rate of interest every six months, but the amount varies based on changes in the principal value.

Every six months, the Treasury updates the principal to reflect changes in the  Consumer Price Index. If inflation goes up, the principal value increases.

Investors holding TIPS to maturity will receive either the adjusted principal amount or the original principal amount, whichever is greater.

What are the advantages and risks of investing in TIPS?

TIPS have indeed outpaced inflation over longer periods. Bonds in most maturity ranges have also outperformed other investment-grade bonds.

But volatility has been higher, as well.

Over the trailing 20-year period through May 31, TIPS with maturities of 10 years or more have been nearly twice as volatile as those with maturities of five to 10 years, but returns have also been lower.

The main reason?

TIPS can be highly sensitive to changes in interest rates. Like other bonds, their principal value declines during periods of rising interest rates, and that may or may not be offset by adjustments for  higher inflation  at the same time. Interest rate risk can be particularly pronounced for TIPS because issuance has historically been weighted more toward longer-term bonds; as a result, most TIPS benchmarks have relatively long durations.

On the extreme end, TIPS with maturities of 10 years and more have lost as much as 41% of their value during interest rate spikes.

When interest rates spiked during the 2013 taper tantrum, TIPS lost significantly more than other investment-grade bonds. And their limited liquidity was a major liability during the global financial crisis in September and October 2008, when TIPS lost nearly 12% of their value.

How to invest in TIPS

Investors have several options for investing in TIPS.

First is purchasing an individual bond through TreasuryDirect or a brokerage account.

Constructing a  TIPS ladder, which is a series of bonds with staggered maturity dates, is another option. Investors seeking a steady stream of income during retirement, for example, could purchase 30 separate sets of TIPS with maturity dates ranging from one year to 30 years from now. Coupons from the bond portfolio and cash flows from maturing bonds can be used to cover each year’s living expenses.

TIPS funds are a bit more straightforward because they don’t require purchasing individual bonds, although they also lack the cash flow-matching properties of a ladder.

In addition, iShares now offers a series of target-maturity TIPS ETFs with maturity dates up to 2036.

How long should I hold my investments in TIPS?

If you’re investing in a TIPS fund, I recommend using one with a short- or intermediate-term maturity and holding it for at least two to six years, as outlined in Morningstar’s  Role in Portfolio Framework.

For individual bonds, you’ll want to match up the timing of when you’ll need the proceeds with the maturity date of the bond. Although the principal value will still fluctuate, interest rate risk is a nonissue if you hold the bond to maturity.

How much of my portfolio should be in TIPS?

If you’re a younger investor, you may not need any exposure to TIPS. Human capital—or the present value of all the earnings you’re going to generate during your lifetime—is likely your largest asset. Because wages normally increase over time to keep up with inflation, this human capital provides a built-in hedge against higher prices for goods and services. Also, your investment portfolio is probably  heavily weighted toward stocks, which are one of the best ways to offset long-term inflation risk.

Investors approaching retirement or already in retirement have a greater need for an inflation hedge to protect their fixed-income holdings. Based on Morningstar’s Lifetime Allocation Indexes, it’s reasonable to allocate 20% to 40% of a portfolio’s fixed-income assets to TIPS.

Individuals who construct a ladder of these bonds to support spending during retirement may be able to allocate a higher percentage of their portfolio to TIPS, but this strategy is designed to be self-liquidating. In other words, a 30-year TIPS ladder will end up with a portfolio balance of zero by the end of year 30. That means retirees concerned about longevity risk or who want to leave money behind for heirs will want to keep some assets invested outside the TIPS ladder to fund those goals.

It’s also important to note that both interest payments and increases in the principal value for TIPS are subject to ordinary income tax. As a result, TIPS are best held in a tax-sheltered account, such as an IRA.

Finally, TIPS aren’t always a compelling portfolio addition. At times, they’ve had negative real yields, which would lead to a loss of spending power over time despite the inflation adjustment.

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This article was provided to The Associated Press by Morningstar. For more personal finance content, go to https://www.morningstar.com/personal-finance.

Amy C. Arnott, CFA, is a portfolio strategist for Morningstar and co-host of The Long View podcast.