TIPS Funds
TIPS Funds
Treasury Inflation-Protected Securities (TIPS) are bonds whose principal adjusts with the Consumer Price Index, offering real (inflation-adjusted) returns guaranteed by the U.S. government.
Key takeaways
- TIPS' principal value rises with inflation and falls with deflation, ensuring the real purchasing power of your return is protected.
- SCHP (Schwab U.S. TIPS ETF) holds short-duration TIPS; VTIP (Vanguard Short-Term TIPS ETF) holds intermediate TIPS; TIP (iShares TIPS Bond ETF) holds all-maturity TIPS.
- TIPS currently yield negative real returns (lower yield than inflation expectations), making them expensive as a return source but valuable as inflation insurance.
- TIPS are best suited for the portion of a portfolio dedicated to inflation protection, not as a substitute for all bond holdings.
- Taxable gain from TIPS inflation adjustment is taxable in the year accrued, even if the bond is not sold—a tax inefficiency in taxable accounts.
How TIPS work
A typical TIPS bond, issued in 2025, might have a par value of $1,000 and a coupon of 1.5%. Semiannually, the bondholder receives a coupon payment equal to 1.5% × the inflation-adjusted principal.
In year one, inflation runs 3%, so the principal is adjusted to $1,030. The bondholder receives a coupon of 1.5% × $1,030 = $15.45, rather than the original $15.00.
If inflation runs 3% in year two as well, principal rises to $1,060.90, and the coupon becomes 1.5% × $1,060.90 = $15.91.
At maturity (typically after 5, 10, or 30 years), the bondholder receives the inflation-adjusted principal value, not the original $1,000.
Importantly, if deflation occurs (prices fall), the principal is adjusted downward, but the Treasury guarantees that you will receive no less than the original par value at maturity. So the worst-case scenario is zero real loss, not a negative real return. This floor is valuable insurance against deflationary scenarios (extremely rare, but they occurred in 2008-2009).
Real yield and nominal yield
TIPS are quoted in two ways: nominal yield (what you see on the trading screen) and real yield (what you earn above inflation).
Real yield = nominal yield - expected inflation.
As of early 2025, the 10-year TIPS yields about 1.8% nominally, while 10-year Treasuries yield about 4.1%. The breakeven inflation rate (implied by the spread between them) is approximately 2.3%. Market participants are pricing in 2.3% average inflation over the next 10 years.
If inflation averages 2.3%, a TIPS holder receiving 1.8% nominal will earn 1.8% - 2.3% = -0.5% in real terms (negative real return). You are paying for inflation protection.
By contrast, a nominal Treasury holder receiving 4.1% will earn 4.1% - 2.3% (if inflation averages 2.3%) = 1.8% in real terms. The nominal holder is being compensated for accepting inflation risk.
This tradeoff is the core choice: do you want real purchasing power protection (TIPS) or nominal return potential (Treasuries)?
When TIPS make sense
TIPS are appropriate when you believe actual inflation will exceed the market's expected inflation (priced into the breakeven rate). If the market expects 2.3% inflation but you believe inflation will be 4.0%, TIPS are attractive. You will earn 1.8% - 4.0% = -2.2% in real terms if inflation actually is 2.3%, but if inflation truly runs 4.0%, TIPS will deliver 1.8% nominal yield while your purchasing power is protected, effectively delivering a 1.8% real return regardless of inflation.
TIPS also make sense for a conservative investor near or in retirement who wants to ensure their purchasing power is not eroded by unexpected inflation. A retiree spending $50,000 per year can buy TIPS to ensure that in 20 years, when inflation may have doubled prices, the bond income will still buy approximately $50,000 worth of goods.
TIPS are less appropriate for a young investor with 40 years to retirement. Younger investors can accept inflation risk (nominal returns are higher) and benefit from their long time horizon to let real wages (which tend to grow with inflation) support bond returns.
SCHP: Short-duration TIPS
SCHP (Schwab U.S. TIPS ETF) holds TIPS with 1-5 year maturities, providing short-duration inflation protection. SCHP's expense ratio is 0.04%, and it typically trades with tight spreads. As of early 2025, SCHP yields about 2.0% nominally, with a breakeven inflation rate around 2.1%. Duration is typically 2-3 years.
SCHP is useful for the portion of a portfolio (perhaps 5-10% of total assets) that needs short-term purchasing power protection without interest rate risk. A conservative investor might hold SCHP to hedge inflation on the first few years of retirement spending.
VTIP: Intermediate-duration TIPS
VTIP (Vanguard Short-Term TIPS ETF, despite the name which is confusing) holds TIPS with roughly 3-10 year maturities, providing intermediate-duration inflation protection. VTIP's expense ratio is 0.04%, and duration is typically 4-6 years.
As of early 2025, VTIP yields about 1.8% nominally, with a breakeven inflation rate around 2.2%. VTIP is the most commonly recommended TIPS holding for a balanced investor wanting broad inflation protection without excessive duration.
VTIP can serve as the inflation hedge in a diversified bond portfolio. An investor holding 60% aggregate bonds and 20% corporate bonds might add 15% VTIP and 5% cash to create a 100-bond allocation that includes inflation protection without dominating the portfolio.
TIP: All-maturity TIPS
TIP (iShares TIPS Bond ETF) holds TIPS across all maturities, from short bonds to 30-year inflation-linked bonds. TIP's expense ratio is 0.20%, slightly higher than SCHP or VTIP due to the complexity of managing a full curve. Duration is typically 6-8 years.
TIP is useful for investors who want to take a strong inflation protection stance and are willing to accept longer duration. It is less commonly recommended than SCHP or VTIP for a basic allocation, but some investors prefer its simplicity (one holding covering the full curve) over holding multiple TIPS ETFs.
Tax inefficiency in taxable accounts
TIPS have a significant tax drawback: the inflation adjustment to principal is taxable in the year it accrues, even if you don't sell the bond. If you hold $10,000 in TIPS and inflation runs 3%, you owe taxes on the $300 principal adjustment in that year, even though you have not yet received the cash (it will come at maturity or sale).
For example, if VTIP yields 1.8% and inflation runs 3%, a $10,000 position generates:
- Coupon: $180 (1.8% × $10,000)
- Principal adjustment: $300 (3% × $10,000)
- Total taxable income: $480
If you are in the 24% federal tax bracket, you owe $115 in taxes on income that has not yet been realized. You must pay this from cash earned elsewhere, creating a cash drag.
This is the primary reason TIPS are best held in tax-deferred accounts (401k, IRA). In a traditional IRA, the $480 in taxable income is deferred until withdrawal. In a Roth IRA, it is never taxed.
In a taxable account, TIPS are suboptimal unless you have a strong belief that inflation will significantly exceed market expectations.
TIPS and nominal bond allocation
Some investors make the mistake of thinking TIPS can substitute for all bond holdings. They cannot. A portfolio of 100% TIPS provides inflation protection but leaves you without the upside of nominal bond returns if inflation comes in lower than expected.
A balanced approach is:
- 70-80% nominal bonds (Treasury, aggregate, or corporate funds)
- 15-25% TIPS for inflation protection
- 5-10% cash or short-term bonds for stability
This allocation ensures that if inflation is lower than expected, the nominal bonds will outperform and provide yield. If inflation is higher, the TIPS will protect purchasing power.
Breakeven inflation and valuation
TIPS valuation depends on the breakeven inflation rate. When breakeven rates are low (market expects low inflation), TIPS are attractive. When breakeven rates are high (market expects high inflation), TIPS are expensive.
As of early 2025, 10-year breakeven inflation is approximately 2.3%, near historical average levels. This suggests TIPS are reasonably priced, neither cheap nor expensive. An investor with a neutral inflation view should be indifferent between TIPS and nominal bonds.
An investor who believes inflation will be higher than 2.3% should overweight TIPS. An investor who believes inflation will be lower should underweight TIPS.
Real returns and the post-2025 environment
The real yield on intermediate TIPS (around 1.8% nominal minus 2.3% expected inflation = -0.5% real) means the bond market is currently expecting slightly negative real returns from TIPS. This is unusual and suggests either the market is mispricing inflation expectations or TIPS are expensive.
Historically, real returns on TIPS have averaged around 1-2% annually. Current yields suggest the market is pricing near-zero or slightly negative real returns, which is conservative. This is not unreasonable given the high inflation environment of 2021-2024, but it also means TIPS are not a source of real return—they are purely insurance against inflation surprise.
Next
TIPS provide inflation protection at a cost. Some investors want higher yield without credit risk or inflation protection complications. Municipal bond funds offer another path: bonds exempt from federal (and sometimes state and local) taxes. The next article explores municipal bond funds and when tax-exempt income is worthwhile.