Inflation-Protected Security (IPS): What It is, How it Works

What Is an Inflation-Protected Security (IPS)?

An inflation-protected security (IPS) is a type of fixed-income investment that guarantees a real rate of return. This means the annual percentage return realized is adjusted for changes in prices due to inflation or other external effects. Expressing rates of return in real values rather than in non-inflation-adjusted terms, especially during periods of high inflation, offers a clearer picture of an investment's value.

Understanding Inflation-Protected Securities (IPS)

Inflation-protected bonds primarily invest in debt securities whose bond principal varies depending on the rate of inflation. The purpose of inflation-indexed investments is to protect an investment’s principal and income stream from the corrosive power of inflation.

The U.S. federal government is currently the leading issuer of these types of securities, primarily in the form of Treasury inflation-protected securities (TIPS) and Series I savings bonds. However, private sector companies also offer these inflation-protected products. One example is corporate inflation-protected securities (CIPS), also referred to as inflation-linked bonds. CIPS are the corporate cousin of TIPS. With the corporate version, the coupon can have a ceiling or not; it can go from a fixed coupon to a floating one, it can be 100% floating and any variation thereof.

All government inflation-indexed securities are benchmarked against the Consumer Price Index (CPI). The CPI measures the prices that consumers pay for frequently purchased items in such industries as transportation, food, and medical care. A sustained increase in the CPI generally indicates that inflation is rising and a dollar’s purchasing power is falling.

Treasury Inflation-Protected Securities (TIPS)

Treasury inflation-protected securities (TIPS) are U.S. Treasury securities that earn a fixed coupon rate and provide protection against inflation by adjusting the principal by the rate of inflation. During times of inflation, the principal increases; during times of deflation, the principal decreases.

Measured by changes in the Consumer Price Index (CPI) and backed by the government, TIPS can be purchased from a bank, a securities broker, the U.S. Treasury, or a securities dealer. Terms issued are 5, 10, or 30 years, and they are sold in $100 increments.

Interest payments are generated semiannually, with interest applied to the adjusted principal. For example, consider a TIP with a principal value of $2,000 and a coupon rate of 1% during a time when the inflation rate is 5%. The principal is adjusted to the rate of inflation, making it $2,100 ($2,000 x 5%). The interest rate is applied to the adjusted principal balance, resulting in a semiannual payment of $10.5 ($2,100 x .5%) or a total annual payment of $21 ($2,100 x 1%).

TIPS can be sold before maturity or held until their maturity date. When TIPS mature, the greater of the original principal or adjusted principal is paid.

Protecting Fixed Payouts from Inflation

If a savings vehicle is delivering a fixed payout, such as a pension or Social Security, inflation can reduce the value of that payout accordingly. Another example is certificates of deposit (CDs), which investors often use to safely tend to their money and avoid the ups and downs of higher-risk assets, such as stock and bonds. However, for long-term investors, CDs may present a different type of risk that can be just as harmful as market risk—the risk of inflation. If the return on an investment does not at least keep up with the rate of inflation, it will result in the loss of purchasing power over the long term.

To illustrate, if a 5-year CD yielded 2%, but inflation grew by an average of 2.5% during that time frame, an investor’s real rate of return would have been -0.5%. In other words, the investor would have lost money because the investment did not keep up with the rate of inflation.

There are strategies an investor can employ to protect their money from inflation. To keep pace with inflation, investors can invest in Treasury-inflation-protected securities (TIPS), whose principal is adjusted for inflation and deflation. For example, during times of inflation, the principal is increased by the rate of inflation, and its fixed coupon rate is applied to the adjusted principal.

Stocks have historically outpaced inflation and could be a good vehicle for investors with higher risk tolerances. For the risk-averse, mutual funds, precious metals, and exchange-traded funds (ETF) might be a viable option since they are not as sensitive to market changes as with stocks.

For those who want to assume no risk, high-yield fixed accounts may be a favorable option. Although these accounts may not keep pace with inflation, they still offer higher yields than traditional savings accounts.