Inflation Is Up, so Why Are TIPS Returns Down?

Treasury Inflation-Protected Securities can be a buffer against long-term inflation, but it's possible for TIPS price declines to outpace principal adjustment in the short term.

Investors holding Treasury Inflation-Protected Securities, or TIPS, as a hedge against inflation may be confused by their performance this year: TIPS prices have declined sharply despite the surge in inflation. Many may wonder: Is this normal?

It's not "normal" for TIPS to fall so much, but it's common for TIPS returns and the rate of inflation to diverge over short periods of time. TIPS can help protect investors against inflation over the long term, but they aren't a hedge against inflation in the short run, because price changes may more than offset the principal adjustment over shorter periods of time. While this year's performance may have investors worried about the outlook for TIPS, we believe the rise in yields and the decline in breakeven rates makes them more attractive today than they have been recently.

Investing in TIPS isn't always straightforward. They have many unique characteristics that can make the investing experience a bit confusing. Here are answers to some of the most frequently asked questions about the TIPS market:

1. What are TIPS?

TIPS are a type of Treasury security whose principal value is indexed to inflation. When inflation rises, the TIPS' principal value is adjusted up. If there's deflation, then the principal value is adjusted lower. Like traditional Treasuries, TIPS are backed by the full faith and credit of the U.S. government.

The coupon payments are based on a percent of the adjusted principal, so investors can benefit from higher income payments when inflation is rising as well.

At maturity, however, a TIPS investor would receive either the adjusted higher principal or the original principal value. In other words, TIPS never pay back less than the initial principal value at maturity.

Principal adjustment and coupon payments for a hypothetical five-year TIPS

Chart shows principal adjustment and coupon payments for a hypothetical 5-year TIPS with an initial principal value of $1,000 and a 1.5% coupon rate. Example assumes 3% annual inflation. At maturity, the principal repaid would be $1,159 and the annual coupon payment would have risen to $17.39.

Source: Schwab Center for Financial Research.