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TIPS, I Bonds Are Smart Ways to Buy Inflation Protection

Illustration by Liam Eisenberg

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As a consumer, it is almost impossible to escape the ravages of inflation, which rose at a 9.1% clip in the 12 months ended June, based on the U.S. Consumer Price Index.

As an investor, however, there are several ways to protect yourself from continued high inflation, chiefly through the purchase of Treasury inflation-protected securities, or TIPS. Most individual investors are unfamiliar with the $1.7 trillion TIPS market, but these Treasury bonds deserve a place in portfolios.

Current yields are high, at around 10%. While TIPS yields should fall if inflation eases in coming months and years, returns could still be ample even if inflation runs at half the current rate. There is little reason to own regular Treasury bonds that now yield around 3%, given the return potential and hedging power of TIPS.

The best way to invest in TIPS is through funds. These include exchange-traded funds such as the

iShares TIPS Bond
ETF (ticker: TIP),

iShares 0-5 Year TIPS Bond
ETF (STIP),

Vanguard Short-Term Inflation-Protected Securities
ETF (VTIP), and

Schwab U.S. TIPS
ETF (SCHP). There are also actively managed mutual funds such as the

Vanguard Inflation-Protected Securities
fund (VIPSX) and

T. Rowe Price Limited Duration Inflation-Focused Bond
(TRBFX).

iShares TIPS Bond ETF / TIP-8.0%10.64%6.59%$31.10.19%iShares 0-5 Year TIPS Bond ETF / STIP-1.110.325.8412.50.03Vanguard Short-Term Inflation-Protected Secs. / VTIP-1.2-0.725.5921.20.04Fund / TickerVanguard Inflation-Protected Securities Fund / VIPSX-7.8%—8.02%$36.70.20%

*SEC yield

Sources: fund reports; Morningstar

Treasury Series I savings bonds offer a simple alternative to TIPS funds, and now pay an interest rate of 9.62% for the first six months on bonds purchased through October.

The main drawback of I bonds is that individuals are limited to $10,000 in annual purchases, although investors can get around that cap. Interest on TIPS, I bonds, and other Treasuries is subject to federal income taxes but exempt from state and local levies.

“Inflation is the No. 1 topic with clients,” says Dhruv Nagrath, a director of fixed-income strategy at BlackRock, which runs iShares ETFs. “TIPS offer a measure of inflation protection for portfolios. They go up in value with inflation.”

Traditional inflation hedges such as stocks and commodities have had a mixed record this year.

The bulk of the return on TIPS comes from an inflation component. The principal value of the bonds is adjusted semiannually based on the consumer price index. Then there is the real yield, which can be positive or negative depending on TIPS demand.

While TIPS track inflation, the value of the bonds can fluctuate based on changes in the real yield. Longer-dated TIPS are more volatile.

This year, iShares TIPS Bond, with an average maturity of about seven years, has had a negative return of 8% despite the positive effect of higher inflation. That’s because real yields on TIPS are up sharply, depressing bond values. The 10-year TIPS real yield is about 0.5%, compared with negative 1% at the start of 2022.

The selloff, however, makes TIPS more appealing and increases the odds of good returns in the future, as investors now get a yield in excess of inflation—hence, a positive real yield.

Another favorable factor is that so-called inflation break-even rates—or the difference in yields between inflation-protected and nominal bonds—have come down about 0.5 percentage point in recent months. The 10-year inflation break-even rate is now 2.3%, meaning that investors will do better owning a TIPS with a current real yield of 0.5% than a 10-year Treasury note yielding 2.8% if inflation runs at more than 2.3% in the next 10 years.

“The break-even rate is too low,” says Rob Arnott, founder and chairman of Research Associates. “This inflation isn’t transitory.”

Arnott expects the housing component to help keep the CPI index in the high-single digits in the next year or two. Nagrath and others favor shorter-dated TIPS funds since their values are less sensitive to changes in real rates.

Unlike regular TIPS, TIPS ETFs don’t generate phantom income. The inflation adjustment added to the price of the bond is taxable income. Direct holders of TIPS have to pay taxes on that income but don’t receive any cash. TIPS ETFs pay monthly or quarterly dividends that align with taxable income.

TIPS can be purchased through the Treasury Direct program and banks and brokers. The Treasury auctions five-, 10-, and 30-year TIPS during the year. Reported TIPS ETF yields can be confusing. IShares 0-5 Year TIPS Bond shows a current yield of 10%, while the similar Vanguard Short-Term Inflation Protected Securities shows negative 0.7%. The iShares yields reflects high recent inflation adjustments while the Vanguard ETF only includes the real yield. Both are permitted under Securities and Exchange Commission guidelines.

Treasury I savings bonds offer no real yield, a negative versus TIPS. An inflation adjustment tied to the CPI index is added twice a year to the value of the bonds. Investors must hold the bonds for at least year, and will lose a quarter’s worth of interest if they are redeemed within five years. But I bondholders can defer paying taxes until the final maturity date in 30 years. This gives these instruments an IRA-like quality. I-bond interest can be tax exempt when proceeds are used for educational purposes.

Inflation AdjustmentPaid MonthlyPaid at MaturityPaid at MaturityFrequency of Income PaymentsMonthly or QuarterlySemi-AnnuallyPaid at MaturityExchange-TradedYesOver-the-CounterNoSet Maturity DateNoYes30 yearsPhantom IncomeNoYesNo

Sources: Blackrock; U.S. Treasury

“Not many people in my world are recommending I bonds to clients because of the small limit on how much you can put into them,” says John Scherer, the founder of Trinity Financial Planning in Middleton, Wis.

Another reason planners don’t push I bonds is that they need to be held at the Treasury and not at custodians like Schwab. Planners who charge wrap fees don’t get paid on I bonds.

Scherer says investors can skirt the $10,000 limit by also investing through trusts and small businesses that are sole proprietorships.

Persistently high inflation is a big risk in the 2020s, and TIPS and I bonds offer investors some of the best protection.

Write to Andrew Bary at andrew.bary@barrons.com

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