Why We Use U.S. Treasury Inflation-Protected Securities (TIPS) in Client Portfolios
U.S. Treasury Inflation-Protected Securities—commonly called TIPS—are a specialized type of Treasury bond designed to help preserve long-term purchasing power by adjusting with inflation. As part of our discretionary investment process, some Crosswalk client portfolios now include individual TIPS.
This article explains what TIPS are, how they work, the tax implications to be aware of, and why they may be used as part of a diversified, risk-appropriate allocation.
What Are TIPS?
TIPS are U.S. Treasury bonds whose principal value adjusts based on changes in the Consumer Price Index (CPI). They are backed by the full faith and credit of the U.S. government.
Key characteristics
- Inflation adjustment: Principal increases during inflation and decreases during deflation.
- Variable interest payments: TIPS pay a fixed coupon rate, but the coupon is applied to the adjusted principal—so interest payments rise and fall with inflation.
- Principal protection at maturity: Investors receive either the inflation-adjusted principal or the original principal, whichever is higher.
- Direct ownership: Crosswalk purchases individual TIPS securities rather than mutual funds or ETFs.
How TIPS Work
TIPS have two primary mechanisms:
- Principal Adjustments
- CPI increases → principal increases
- CPI decreases → principal decreases
These adjustments accumulate over the life of the bond.
- Coupon Payments
Because the coupon rate is applied to the inflation-adjusted principal, interest payments change depending on inflation levels. This structure ties TIPS performance to realized inflation.
Understanding the Tax Treatment (Including “Phantom Income”)
TIPS offer inflation protection, but they also receive unique tax treatment, particularly in taxable accounts.
- Inflation Adjustments Are Taxable
Even though principal increases are not received in cash, the IRS treats them as taxable interest income, often called “phantom income.”
- Coupon Interest Is Also Taxable
Semiannual coupon payments are taxed as ordinary federal interest.
- Federal-Only Taxation
Both inflation adjustments and coupon payments are:
- Taxable at the federal level
- Exempt from state and local income tax
- Tax-Time Impacts
Inflation adjustments may:
- Increase federal tax liability
- Affect estimated tax payments
- Influence IRMAA, NIIT, and other income thresholds
This is simply an inherent feature of how TIPS are structured.
Schwab’s Annual 1099 Composite Statement
Each year, Charles Schwab & Co., Inc. provides clients with a 1099 Composite Statement that consolidates all tax forms for the prior year.
Brokerage firms must deliver Forms 1099 by January 31, though corrected versions may be issued later if updates occur.
The Schwab composite statement typically includes:
- Form 1099-INT – coupon interest
- Form 1099-OID – inflation or deflation principal adjustments
- Form 1099-B – if a TIPS was sold or matured
Clients should provide this composite statement to their tax preparer to ensure accurate reporting.
Risks of TIPS
TIPS help manage inflation risk, but they come with other investment risks:
- Interest-Rate and Real-Rate Risk
TIPS prices can decline if real interest rates rise.
- Inflation Expectation Risk
If future inflation turns out lower than expected, TIPS may underperform nominal Treasuries.
- Short-Term Volatility
TIPS can fluctuate during shifts in Federal Reserve policy, inflation expectations, or bond-market conditions.
- Tax Timing
Phantom income may result in federal tax liability without matching cash flow.
Because of these factors, TIPS may be more tax-efficient in:
- IRAs
- Roth IRAs
- Other tax-advantaged accounts
However, they can still be appropriate in taxable accounts when used thoughtfully within a financial plan.
Why We Use TIPS in Certain Client Portfolios
Our use of TIPS reflects disciplined portfolio construction and long-term planning principles.
- Protecting Purchasing Power
Inflation erodes the value of fixed-income streams.
TIPS are the only U.S. government securities that adjust principal for CPI.
- Diversification Benefits
TIPS behave differently from:
- Nominal Treasuries
- Corporate bonds
- Equities
This can help balance risk within a diversified allocation.
- Long-Term Inflation Uncertainty
Inflation uncertainty remains elevated due to factors such as:
- High federal debt and deficits
- Demographic trends affecting labor supply
- Ongoing supply-chain restructuring
- Infrastructure and energy-demand pressures
- Global geopolitical dynamics
These are not forecasts—only factors widening the range of possible inflation outcomes.
- Attractive Real Yields
When real yields are reasonable, TIPS may offer a favorable long-term risk profile relative to other defensive assets.
- Alignment With Financial Planning
We incorporate TIPS only when consistent with a client’s:
- Time horizon
- Cash flow needs
- Tax circumstances
- Risk tolerance
- Broader long-term goals
Questions? We’re Here to Help
We are always available to review how TIPS may fit within your long-term investment strategy or to coordinate with your tax professional as needed.
Important Disclosures
Crosswalk Investment Advisory, Inc. is a Registered Investment Adviser. Registration does not imply a certain level of skill or training. Advisory services are provided only to clients or prospective clients where Crosswalk Investment Advisory, Inc. and its representatives are properly licensed or exempt from licensure.
This article is for informational and educational purposes only and does not constitute tax, legal, or accounting advice. Clients should consult their tax professional regarding their personal situation. Nothing in this article should be interpreted as a recommendation to buy or sell any security or to adopt any specific investment strategy.
All investments involve risk, including the potential loss of principal. Inflation-indexed securities may fluctuate in value based on real yields, interest rates, inflation expectations, and broader market conditions. Past performance is not indicative of future results.
Custody and brokerage services are provided by Charles Schwab & Co., Inc., member SIPC.
For additional information about Crosswalk Investment Advisory, Inc., please refer to our Form ADV, available upon request.