Looking for inflation protection, TIPS should be on your radar

In all the hoopla to grab I bond’s high rate before it slid this month, Treasury inflation-protected securities, or TIPS, took a backseat for many inflation-spooked investors.

But they’re worth considering if you’re looking for long-term inflation protection. TIPS are a type of Treasury security whose principal value is indexed to inflation. When inflation climbs, the TIPS’ principal value is adjusted upward.

That should appeal to investors who are considering purchasing I bonds, which combine a 6.48% annualized rate of inflation with a 0.40% fixed rate because TIPS is beating that right now.

“Currently, TIPS have a larger real yield than I bonds,” Ken Tumin, a senior industry analyst at LendingTree and founder of DepositAccounts.com, told Yahoo Money. “The I bonds real yield, the fixed rate, went up to 0.4% in November, but TIPS have real yields that have been in the range of 1.40% to 1.80%.”

Here’s what to know.

Pros of TIPS

While I bonds certainly deserved the klieg light, TIPS can deliver more yield over the long run when consumer prices jump and are not as constricted in terms of how much you can buy, where to purchase, how long you must hold them, and what types of accounts they can be held in.

These bonds are also issued by and backed by the United States Government.

With I bonds, you’re generally limited to purchasing $10,000 per calendar year. But with TIPS, an investor can buy as much as $10 million. This can make a huge difference for someone who wants to obtain a large degree of inflation protection.”

There are also more purchase options, as you can purchase TIPS directly from TreasuryDirect.gov, through a brokerage account, or via a dedicated mutual fund or ETF such as Fidelity Inflation-Protected Bond Index Fund (FIPDX) or T. Rowe Price Inflation Protected Bond Fund (PRIPX) or Goldman Sachs Access Inflation Protected US Bond ETF.

With I bonds, you can only purchase them through TreasuryDirect.gov.

“Not only can you buy TIPS from TreasuryDirect, but you can also buy TIPS from a brokerage firm,” Tumin said. “TIPS can be easily purchased inside retirement accounts such as IRAs, and TIPS can be bought indirectly through mutual funds and ETFs.”

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You can’t buy I bonds within a traditional IRA, Roth IRA, or employer-sponsored savings plan, such as a 401(k) plan. So you’ll need to buy I bonds with savings outside of these programs.

TIPS are sold for a term of 5, 10, or 30 years.TIPS’ yields are based on their current amount of principal. When the Consumer Price Index for all Urban Consumers (CPI-U) rises, the principal of TIPS adjusts higher, and the payments move in step with it.

So unlike I bonds, the principal of a TIPS can go up or down over its term. The rate is adjusted by using this version of the Consumer Price Index from the Bureau of Labor Statistics. You can check out the daily index ratios to see how your TIPS principal is changing.

Because interest is paid on the adjusted principal, the amount of interest payment also varies. You can hold a TIPS until it matures or sells it before it matures. When the TIPS matures, if the principal is higher than the original amount, you get the larger amount. If the principal is the same as or less than the original amount, you get the original amount.

And TIPS are completely liquid. You can sell them at any time. I bonds need to be held for at least a year, and you’ll forfeit a quarter’s worth of interest if you redeem an I bond before five years.

TIPS drawbacks

There are some negatives to TIPS, Tumin pointed out.

“Individual TIPS can have a negative yield if sold before maturity,” Tumin said. “TIPS mutual funds and ETFs can also have a negative yield as we’ve seen this year. I bonds are guaranteed to never have a negative yield.”

There’s also the tax consequence.

“Unlike I bonds, you can’t defer federal income tax until redemption,” Tumin said. “Federal income taxes are owed yearly on TIPS when held in taxable accounts.”

Kerry is a Senior Columnist and Senior Reporter at Yahoo Money. Follow her on Twitter @kerryhannon

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