Investors Look to Hedge Inflation with TIPS

Most bonds pay investors a set amount of interest semiannually and then pay the original face value of the bond at maturity; TIPS, however, are marketable securities whose principal is adjusted by changes in the Consumer Price Index. 

The assets in TIPS funds surged and have now nearly doubled since 2018 to about $295 billion, according to the Wall Street Journal.

TIPS-focused ETFs and mutual funds outperformed other bond funds last year for the second consecutive year, with 2021 total returns of 5.5% on average, compared with -1.7% for a U.S. bond index fund, according to Morningstar.

The principal of a TIPS increases with inflation and decreases with deflation, as measured by the CPI. The relationship between TIPS and the CPI affects both the sum you are paid when your TIPS matures, as well as the amount of interest that a TIPS pays.

TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal, so interest payments can vary in amount from one period to the next. As inflation increases, the interest payment increases. In the event of deflation, the interest payment decreases.

TIPS are issued in five-year, 10-year, and 30-year maturities. At the maturity of a TIPS, you receive the adjusted principal or the original principal, whichever is greater, which protects investors against deflation.

A large downside of holding individual TIPS as an investor is the complex tax consequences. Even though holders will not collect any growth in TIPS’ face value until the security matures or the investor sells, holders must pay federal taxes on any gains in face value.

Investors can avoid this tax implication by investing through pooled invest vehicles, especially tax-advantageous ETFs such as the FlexShares iBoxx 3 Year Target Duration TIPS Index Fund (TDTT A-) and the FlexShares iBoxx 5-Year Target Duration TIPS Index Fund (TDTF B+).

TDTT hauled in $20 million in assets from investors in January, putting it in the top three in terms of inflows into FlexShares ETFs.

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