Are TIPS Working as Intended?

For Treasury Inflation-Protected Securities (TIPS)—whose par, or principal, value increases or decreases based on the rate of inflation (as measured by the Consumer Price Index)—last year's 40-year high in inflation was supposed to be a boon. But prices for existing TIPS actually declined. So, what gives?

As with all bonds, TIPS prices and yields move in opposite directions. When yields rise—which was the case for most of the bond market in 2022 as the Federal Reserve increased interest rates—prices fall for existing bonds that were issued when interest rates were lower.

For example, say you own a 5-year TIPS with a par value of $1,000 and an interest rate, or coupon, of 1%. If inflation increases 5%, the value of the principal also increases 5%, to $1,050—and so does the income, to $10.50.

However, if a newly issued 5-year TIPS offers a 2% coupon, it will produce income of $20—far outpacing your original TIPS even after its inflation adjustment. So, if you need to sell your original TIPS prior to maturity, you'll have to do so at a discount to compensate the buyer for the lower rate of return vis-à-vis the new TIPS.

"What made last year's price declines so remarkable was how far they fell in such a short time," says Collin Martin, CFA^®, a director and fixed income strategist at the Schwab Center for Financial Research. "Even though their principal values were adjusted upward due to inflation, it wasn't enough to offset the plunge in prices, which averaged 19% for the year."

That said, price drops impact only those investors who need to sell their TIPS prior to maturity. "TIPS are designed to help protect against inflation over the long run, so only by selling early do you risk locking in those losses," Collin says. "If you're able to hold on till maturity, you'll get either the increased [inflation-adjusted] price or the original principal—whichever is greater."