Treasury Inflation Protected Securities (TIPS) have become popular because the principal is adjusted upwards every six months to provide inflation protection to bondholders. However, TIPS come with risks, too:
* If market interest rates rise faster than inflation, TIPS returns can fall behind. Some analysts are warning of deflation, not inflation, so this risk should be considered.
* Any increase in principal due to an inflation adjustment is taxed in the year of the adjustment, although the cash is not received until the TIPS matures. Because of this aspect, some people choose to hold TIPS in a tax-deferred account, such as an IRA.
The immediate taxability of the inflation adjustment may influence the decision of whether to purchase individual TIPS or a TIPS fund. Individual TIPS have a fixed interest rate and maturity date. Funds invest in a variety of TIPS at different interest rates and different maturities, then distribute the interest and increased principal payments on a monthly basis.
Thus, a fund has less certainty in terms of returns but greater flexibility and the potential for higher returns. In addition, because funds pay out the principal growth every month, fund investors receive the cash flow on the inflation adjustment in the same year they pay the tax on the adjustment. With a TIPS fund, there’s no penalty for holding these securities in a taxable account.
