In the bond fundamentals chapter, we learned about the risks of inflation. Fixed income securities (preferred stock and bonds) are particularly susceptible to inflation. If you owned a $1,000 par, 5% bond, it would pay you $50 a year in interest. $50 might buy a fair amount today, but after 20 years of high inflation, that same $50 might not even cover an average deli sandwich.
Now let’s scale that up. Assume a retired investor buys a large number of bonds and currently receives $50,000 in annual interest. They need this amount of money in 2026 to pay for living expenses. At an annual inflation rate of 3%, 20 years later they’ll require roughly $90,000 of annual income to maintain the same purchasing power. If the investor bought 20-year fixed-interest-rate bonds, those bonds still pay the same $50,000 each year. That gap is the inflation problem for bond investors.
To help keep pace with inflation, investors can keep a portion of their portfolio invested in the stock market, which tends to outpace inflation over long periods of time. If the stock market is too risky for the investor, they can consider investing in TIPS.
Treasury Inflation Protected Securities (TIPS) are long-term debt securities issued by the US Government that pay semi-annual interest to investors. Unlike securities like Treasury bonds, TIPS are designed to increase payments when inflation rises. To see how, let’s walk through an example.
30-year TIPS issued
TIPS are typically issued at par with a fixed coupon. In this example, the 30-year TIPS have a 3% coupon, which is always fixed (it doesn’t change). At issuance, the security pays $15 twice a year ($30 in annual interest).
The inflation protection comes from the principal (par) value, which changes over time. Every six months, TIPS adjust principal based on Consumer Price Index (CPI) levels. As a reminder, CPI is the government’s measure of inflation as measured by the U.S. Bureau of Labor Statistics. Each month, CPI tracks price changes for a basket of goods and services across the United States.
When CPI rises, inflation is rising. When inflation rises, the TIPS principal is adjusted upward, and interest payments rise because interest is calculated on the adjusted principal.
For example, here’s what happens if CPI rises by 2% over six months.
30 year TIPS adjustment (+2% CPI)
Here’s the logic:
This adjustment continues throughout the life of the TIPS. TIPS are issued in 5, 10, and 30-year maturities, so over long periods the adjusted par value can become much larger than the original par.
At maturity, the investor will always receive the greater of the original par value (typically $1,000) or the adjusted par value. If inflation has risen over time, this feature can increase the investor’s payout at maturity.
While inflation is more common, deflation can also occur. Deflation means prices fall instead of rise. Lower prices can sound appealing, but deflation often comes with falling wages and revenues, and it can discourage spending. If prices are falling, people and businesses may delay purchases (for example, waiting to buy a car because it may be cheaper later). That reduced spending can slow economic output and leave businesses with inventory they can’t sell.
When deflation occurs, TIPS adjust as well. Using the same starting point:
30-year TIPS issued
What would be the result if CPI reported a 4% annual fall in prices? Specifically, what is the adjustment to the par value and the next interest payment?
With an annual falling CPI rate of 4%, the par value adjusts after 6 months at a rate of -2% (half of the annual 4% decline). 2% of $1,000 is $20, so the par value will fall to $980.
Now, calculate the fixed coupon (3%) based on the adjusted par value ($980). This results in a new annual rate of $29.40, leading to semi-annual interest payments of $14.70 ($29.40 / 2).
The maturity rule (receiving the greater of original par or adjusted principal) is especially important during deflation. Even if the adjusted principal falls below the original par ($1,000 in this example), the investor still receives the original par value at maturity.
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