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TIPS, short for Treasury Inflation-Protected Securities, are bonds which provide a degree of inflation-protection and are backed by the full faith and credit of the United States government. The principal of a TIPS increases with inflation (as tracked by the CPI-U published monthly by the Bureau of Labor Statistics) and decreases with deflation, and interest is paid out on the adjusted principal semi-annually. TIPS are sold with 5/10/20 year maturities, and at maturity, the inflation-adjusted principal is paid out, or if the adjusted principal is less than the original principal, the original principal is repaid, thus providing protection against deflation as well. TIPS were invented by the Treasury in the late 1990s because Treasury bonds ran the risk of being eroded by inflation, and there was a demand for a product that guaranteed a return over and above inflation. The TIPS spread, which is the difference between the 10 year TIPS and the 10 year Treasury bill, is a market-based measure of inflation expectations.

TIPS are sold to individual retail investors through the TreasuryDirect website, as well as through many brokerages. However, directly owning TIPS comes with several disadvantages. Firstly, IRS considers adjustments to the principal of TIPS to be taxable, although this is only a paper gain/loss. For this reason, most people should directly own TIPS only in a tax-advantaged account. Secondly, the secondary market for TIPS is not very liquid, and typically you incur a hefty sales commission and bid-ask spread to sell TIPS before maturity. (TreasuryDirect does sell the I-bond, which is similar to TIPS but is saleable back to the government at any time after one year, but I-bond sales is limited to only $5000 per person per year.) If you want to hold TIPS to maturity, and do not mind the tax hassles, then direct ownership is the cheapest way to go. However, there are two ETFs on the market (TIP and IPE) that substantially reduce the hassles of owning TIPS. You can buy and sell these TIPS ETFs like stocks, and they are treated tax-wise like a normal stock or bond, and are extremely liquid. For these advantages, you pay an expense ratio of 0.2%, and a 1.1-1.2% premium over the NAV, as well as brokerage trading commissions.

I am primarily interested in TIPS because I feel that inflation in the future is almost inevitable if we are pull through the current crisis with only a mild recession, and I am looking for some protection against inflation since substantially all of my portfolio is in US dollars. Certainly, a large fiscal stimulus which balloons the deficit is very likely on the horizon, and even normally fiscally conservative economists feel that now is not the time to worry about budget deficits. Furthermore, there are many indications that TIPS are currently irrationally undervalued. The financial crisis has led to investors fleeing every investment except for Treasury bonds, even investments such as Agency bonds and TIPS, which are also backed by the government, leading to an incredibly high TIPS yield. At one point, due to the rush to Treasury bonds, the yield on 5-year TIPS were briefly higher than that of the 5-year Treasury bill (TIPS normally yield lower than Treasuries because of their inflation protection). Even the Federal Reserve has stopped tracking the TIPS spread, which is basically tacit acknowledgement that the current prices for TIPS are irrational. Both TIPS ETFs are now boasting a dividend yield of 8-10%, for bonds that are backed by the full faith and credit of the US government, while ETFs for long-term Treasuries, also backed by the government, sport a dividend yield of only 3-4%.

Are there any risks to this investment? I consider credit risk to be nil, since TIPS are basically as safe as Treasuries. Because ETFs are traded on the open market, there is theoretical risk that the market price may deviate substantially from NAV, although large deviations for extended periods are impossible because the ETFs are open-ended and the manager can create and redeem units. In practice, both TIP and IPE command a 0.5-1.5% premium over their NAV. The only risk involved is deflation risk, which would erode the principal of the underlying TIPS and decrease NAV. However, deflation would be cataclysmic for the US economy, and the Federal Reserve will certainly do everything possible to prevent that from happening. Indeed, I cannot justify the purchase of any stocks in the US if I really think that deflation will occur, since deflation is usually accompanied by a very high unemployment rate and a stagnant economy for many years (e.g. the Great Depression in the US, and the lost decade in Japan).

In conclusion, TIPS ETFs are exceedingly safe investments that are currently (and probably temporarily) sporting an abnormally high return. I have begun to scale into TIP, and will probably continue to scale all of my cash into TIP while I scout for extremely undervalued stocks in defensive industries to invest in.