One of the fears that many investors have when it comes to their returns is the eroding effect of inflation. Unfortunately, most investments that are considered “low risk” have low rates of return – some of which won’t even beat inflation. While you can offset inflation with some riskier investments, many still like to have some safety in the portfolio, just in case. One way you can help your safer investments at least keep pace with inflation is to invest in Treasury Inflation Protected Securities (TIPS).

What are TIPS?

In 1997, the Treasury introduced TIPS as a way to lure long term investors to government bonds. When you invest in TIPS, you are basically making a loan to the U.S. government. Every six months, you receive an interest payment on your bonds. This is pretty standard with all Treasury investments. However, with TIPS there is a little added bonus: Your payment is adjusted with inflation. So, as inflation goes up, so does your payment, helping you to retain your purchasing power.

One of the drawbacks to TIPS, though, is that the interest rate paid is actually a little bit lower than other Treasury bonds. This interest rate is the fixed rate you receive on the bond. This can be somewhat discouraging to some, until they factor in the idea that you are still coming out ahead since you are earning a return, and you are protected against inflation. Other bonds may have higher rates, but if inflation erodes the returns, you can still lose money.

What actually changes in TIPS is your principal. Every six months your principal is adjusted to reflect the inflation rate. The government uses the Consumer Price Index to determine the annual inflation rate. Every six months, the government takes half that inflation rate and adds it to your principal. So if you have $12,000 invested in TIPS, and the annual inflation rate is 3%, every six months your principal is adjusted by 1.5%. So, after six months $180 is added to your principal. Your fixed interest rate is now being applied to a principal of $12,180, meaning that you will earn more interest during that six months, since you will be earning returns on a higher principal. The down side, of course, is that your principle can be adjusted down if inflation starts to fall.

One thing to be aware of, though, is that you do not receive the increases in your principal until after the bond matures. You may receive your interest payment, but you will not get your principal interests until the rest of your principal is returned. But this doesn’t mean that you aren’t taxed on the increase. That $180 principal increase mentioned above is considered regular income – even though you don’t actually have the cash in hand. So you will have to report it as income, and pay regular taxes on it. One to reduce the impact of this reality is to hold your TIPS in a tax-deferred retirement account. That way, you will not have to pay taxes on the principal increases until you start withdrawing from your retirement account.

In theory, it is possible to lose your principal with TIPS if the U.S. government defaults on its debt. However, in practice there is a very low possibility of such a scenario. U.S. government debt is considered generally low risk, backed as it is by the most stable taxpayer base in the world. (This is one of the reasons that yields are fairly low on Treasuries; there is a trade off between safety and potential returns.)

Purchasing TIPS

Investing in TIPS is fairly simple and straightforward. One of the easiest ways to invest in TIPS is to go to TreasuryDirect and get them straight from the source. You can set up an account, and purchase TIPS in increments of five, 10 or 30 year maturities. Realize that your money will be tied up for at least five years, so if you think you will need access to the principal sooner than that, you should consider another investment. Also, you can ladder your TIPS so that you have a chance to invest at higher rates if the yield has increased.

TIPS are issued only in electronic form, so you have to have an account set up, and you will not get a paper bond. You can buy TIPS in increments of $100 – an amount that is also the minimum purchase. You can purchase up to $5 million in TIPS when engaged in noncompetitive bidding.

There are two main types of bids when buying TIPS:

• Noncompetitive: This is the more common way for ordinary folks to purchase TIPS. You buy at auction, and simply agree to the yield determined at the auction. You get the TIPS you want, and in the amount you want. It is very straightforward.
• Competitive: You can also buy TIPS with a competitive bid. You specify the yield that you want on your TIPS, and then wait to see what happens. If your bid is less than the auction bid, you will receive the full amount. However, if your bid is equal to the high yield, you will not get the full amount of TIPS that you want. Finally, if your yield requirement is higher than what is set at the auction, your bid will be rejected altogether.

While TreasuryDirect is one of the easiest ways to purchase TIPS, you can also use other methods to buy them. A bank, broker or dealer can help you with your TIPS, and can be especially helpful if you plan to hold TIPS in a tax advantaged retirement account. However, you may have certain fees to pay if you have someone aid you in your purchase of TIPS. It is also worth noting that TIPS can be purchased in exchange traded funds and in mutual funds. Indeed, some income mutual funds feature TIPS as part of the mix.

Bottom line: If you are interested in adding a little safety to your investment portfolio, and if you are interested in ensuring that your low risk investment beats inflation, TIPS might be something to consider.