Everything Investors Need to Know About TIPS | ETF Trends

Investors looking for a way to hedge against inflation are increasingly looking to TIPS, or Treasury inflation-protected securities.

A commonly held belief is that by the time you hear about TIPS, like when they’re making headlines and raking in new assets, you’re too late to the party. However, the massive inflows into the FlexShares iBoxx 3 Year Target Duration TIPS Index Fund (TDTT) tell a different story. 

TDTT has seen $109 million in net inflows over a four-week period, and $668 million in net inflows year-to-date, according to ETF Database. 

TIPS are securities issued by the U.S. Treasury that are designed to provide inflation protection to investors. TIPS are income-generating instruments whose interest and principal payments are adjusted for inflation, making them highly attractive in the current environment.

The assets in TIPS funds surged and have now nearly doubled since 2018 to about $295 billion, as of February, 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 seeing total returns of 5.5% on average, compared with -1.7% for a U.S. bond index fund, according to Morningstar, suggesting that investors may be chasing performance in their decisions to allocate to 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 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 an investor is paid when their 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 maturity, an investor receives the adjusted principal or the original principal, whichever is greater, protecting 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, including tax-advantageous ETFs such as TDTT and the FlexShares iBoxx 5-Year Target Duration TIPS Index Fund (TDTF).

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