TIPS Explained: When Inflation-Protected Treasuries Beat Regular Bonds

Put $10,000 into a 10-year Treasury Inflation-Protected Security with a 1.75% coupon, and suppose prices rise 3% over the next year. By the end of that year, your principal is no longer $10,000. It has been adjusted to about $10,300, and every interest payment from then on is calculated on the larger number. A regular Treasury note bought the same day would still have a $10,000 principal, no matter what happened to grocery prices. That single difference, a principal that moves with inflation, is what TIPS are built around, and it explains both their appeal and their quirks.

The numbers above are a hypothetical illustration, not a quote of current rates. TIPS coupons are set at auction, and both TIPS and regular Treasury yields change daily. This article is general education rather than personal investment or tax advice.

How the principal adjusts

TIPS are marketable Treasury securities sold in 5-, 10-, and 30-year terms, in $100 increments with a $100 minimum, according to TreasuryDirect. Unlike other Treasuries, where the principal is fixed, the principal of a TIPS goes up with inflation and down with deflation. Treasury makes that adjustment using the Consumer Price Index for All Urban Consumers (CPI-U), published by the Bureau of Labor Statistics.

The adjustment works through an index ratio. Each TIPS issue has a reference CPI from when it was created, and each day Treasury compares the current reference CPI to that starting point. If the ratio is 1.03, your adjusted principal is 103% of the original face value. The index uses CPI figures with a lag of a few months, so the adjustment you see today reflects inflation that was measured a little while ago. Treasury publishes the daily index ratios, which is how brokers and TreasuryDirect value your holding.

In practice, this means you are not guessing about inflation when you buy. You are agreeing to receive a fixed real return on top of whatever inflation turns out to be over the life of the bond.

The coupon rides on a moving base

TIPS pay interest every six months at a fixed rate set at auction. TreasuryDirect notes that the rate is never set below 0.125%, even when the auction produces a lower or negative real yield, in which case buyers pay a premium. What changes is the amount of each payment, because the fixed rate is applied to the adjusted principal at the time of the payment.

Continuing the example, a 1.75% coupon means 0.875% every six months. If the adjusted principal is $10,150 at the first payment date, you receive about $88.81. If it is $10,300 at the second, you receive about $90.13. When inflation runs hot, your payments grow. When inflation cools, they grow more slowly. If prices actually fall, the principal shrinks and the payments shrink with it.

That is the core trade. A regular Treasury pays a higher fixed coupon in nominal dollars. A TIPS pays a lower fixed coupon, but on a principal that keeps pace with the CPI.

The deflation floor, and what it really protects

At maturity, Treasury pays the greater of the inflation-adjusted principal or the original principal. You never get back less than the original face value if you hold to maturity. That is the deflation floor, and it is a real feature, but it is narrower than many people assume.

First, the floor applies only at maturity. If deflation shrinks your adjusted principal during the bond's life, your interest payments shrink too, and nothing makes up that difference.

Second, the floor protects the original par value, not any inflation you paid for. Suppose you buy an older TIPS on the secondary market after years of inflation, when its index ratio is 1.25. You are effectively paying for $12,500 of adjusted principal per $10,000 of face value. If prolonged deflation pushed that ratio down to 1.10 by maturity, you would receive the adjusted $11,000, not the $12,500 you paid for. The floor only kicks in below $10,000. Newly issued TIPS have an index ratio close to 1.00, so the floor is most valuable to people who buy at auction.

Third, the floor says nothing about market price. TIPS trade like other bonds, and their prices fall when real yields rise. Sell before maturity and you can lose money even in an inflationary year.

Phantom income: the tax catch

Here is the part that surprises most first-time TIPS owners. The IRS treats each year's increase in the inflation-adjusted principal as taxable income in the year it happens, even though you do not receive that money until the bond matures or you sell it. IRS Publication 550 says holders of inflation-indexed debt, other than Series I savings bonds, must report as original issue discount any increase in the inflation-adjusted principal that occurs during the year. You should receive Form 1099-OID showing the adjustment along with the interest actually paid.

In the example, the $300 increase in principal during a 3% inflation year is taxable federal income, on top of the roughly $179 in coupons you actually received. In a 22% federal bracket, the tax on that $300 adjustment alone is $66, paid with cash from somewhere else. That is why it is called phantom income. When principal decreases in a deflationary year, the decrease can generally reduce the interest income you report, which softens the blow but does not erase the timing problem in high-inflation years.

TIPS interest and adjustments are exempt from state and local income tax, as with other Treasuries. Still, the federal phantom income issue is a big reason many investors hold TIPS inside a traditional IRA, Roth IRA, or workplace plan, where annual tax reporting does not apply. In a taxable account, TIPS work best for people who can comfortably pay tax on income they have not received yet.

Breakeven inflation: the number that decides who wins

Whether TIPS beat regular Treasuries comes down to one comparison. Take the yield on a regular Treasury of a given maturity, subtract the real yield on a TIPS of the same maturity, and the difference is the breakeven inflation rate.

Say a 10-year Treasury note yields 4.2% and a 10-year TIPS has a real yield of 1.9%. The breakeven is 2.3%. If CPI inflation averages more than 2.3% a year over the next decade, the TIPS should come out ahead if both are held to maturity. If inflation averages less, the regular note wins. These are illustrative figures, so check current yields on Treasury's website or your broker before comparing.

Breakeven also contains a small risk premium, and TIPS have historically been somewhat less liquid than regular Treasuries, so the comparison is not perfectly clean. Even so, it gives you a practical question to ask yourself: do I believe, or do I need protection against the possibility, that inflation will run above the rate the market is pricing in?

Situations where TIPS tend to come out ahead

When you have a future bill in real dollars. A retiree who needs a set amount of purchasing power in five or ten years, or a family funding expenses that will rise with prices, can match those needs with TIPS maturing on the right dates. Some retirees build TIPS ladders, buying issues that mature each year to cover a portion of their spending.

When inflation surprises to the upside. TIPS are explicit insurance against inflation beating expectations. If inflation runs well above breakeven for years, TIPS holders are compensated and nominal bond holders are not.

When you want Treasury credit quality with a real return. TIPS carry the backing of the U.S. government, so the main risks are interest rate risk and the inflation outcome, not default.

Situations where regular bonds may be the better fit

When inflation comes in below expectations. If CPI averages less than breakeven, you would have earned more with a nominal Treasury.

When you might need to sell soon. Because TIPS prices move with real yields, they can drop in value even while inflation is high, as many holders discovered when real yields rose sharply in 2022. A short-term need is often better served by T-bills or a savings account.

When the money is in a taxable account and cash is tight. Paying annual tax on phantom income can be a real drag if you are relying on the coupons for spending.

When your personal inflation differs from CPI-U. TIPS track a broad urban consumer index. If your costs are dominated by things that rise faster, like health care or tuition, TIPS will not match your exact experience.

TIPS versus I bonds

Series I savings bonds are the other inflation-linked Treasury product, and the two are easy to confuse. I bonds pay a composite rate made up of a fixed rate plus an inflation rate that resets every six months, and TreasuryDirect states the combined rate can go down but the bond's value does not fall. They are nonmarketable, so there is no market price risk.

The trade-offs are significant. I bonds are limited to $10,000 per Social Security number per calendar year in electronic form. You cannot cash them for the first 12 months, and if you redeem within five years you lose the last three months of interest. On the tax side, I bonds let you defer federal tax until you redeem them or they stop earning interest after 30 years, which avoids the phantom income problem entirely. Like TIPS, they are free of state and local income tax, and the interest may be tax-free for qualified higher education expenses.

TIPS have no annual purchase cap at auction beyond Treasury's large noncompetitive limit, can be sold any business day through a broker, and pay interest twice a year. So I bonds tend to suit smaller, set-aside savings, while TIPS suit larger allocations, retirement accounts, and investors who need liquidity or scheduled maturities. Many people use both.

Ways to own them

You can buy new TIPS at auction through TreasuryDirect or a brokerage using a noncompetitive bid, which guarantees you get the security at the auction's yield. TreasuryDirect lists 5-year originals in April and October, 10-year originals in January and July, and 30-year originals in February, with reopenings in other months. Brokerages also let you buy existing TIPS on the secondary market, where you can pick exact maturities but should watch the index ratio and the price.

TIPS mutual funds and ETFs offer diversification and easy trading. Keep in mind that a fund never matures, so you do not get the at-maturity floor or a known payout date, and fund prices move with real yields. Funds generally pass the inflation adjustments through as taxable distributions, so the tax drag is still there in a taxable account.

The bottom line

TIPS beat regular bonds when inflation runs above the breakeven rate priced in today, and when you value a guaranteed real return more than a higher nominal coupon. If you are funding real-dollar needs years from now, check the current breakeven, hold TIPS in a tax-advantaged account where you can, and buy at auction to get the full benefit of the deflation floor.