The Sad Story of TIPS and Why There's No Silver Bullet to Fight Inflation

In 1997, the U.S. government introduced a new type of Treasury bond, called Treasury Inflation-Protected Securities (TIPS), that was hailed as a solution to the inflation problem.

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Inflation is the bane of wealth accumulation. Over time, it reduces buying power. This is why people, especially retirees, are always searching for ways to keep inflation from whittling away at their money.

In 1997, the U.S. government introduced a new variety of Treasury bond that was welcomed by investors as a solution to the inflation problem. This new form of government debt was called Treasury Inflation-Protected Securities (TIPS).

These investments pay investors two interest rates: a rate fixed for the life of the bond and another rate based on inflation. As it does with other Treasury bonds, the government adjusts the fixed rate periodically for new issues, based on various economic factors. The inflation-based interest rate varies on new and existing TIPS according to the urban consumer price index (CPI-U). So if you own TIPS and inflation spikes, the government pays you more interest to cover this.

TIPS grew quickly in popularity, and were praised for years as an inflation solution that would stand the test of time for new investors. But currently, TIPS are a different story entirely, ironically because they became so popular so fast. The relatively short, happy popularity of TIPS is an object lesson in the effects of demand on pricing and how there is no silver bullet for fighting inflation.

Initially, TIPS paid a healthy fixed (non-inflation) rate. For example, early on, issues of TIPS were offered in the low single digits, considered to be all gravy because of the inflation-based rate. Inflation has generally run well under 3 percent during the 16 years of TIPS' existence. So, with this historically low rate, there hasn't been much inflation to be protected from during TIPS' lifetime.

Yet, it's the inflation-based interest paid that has spurred demand for TIPS by retirees, because you never know what will happen to the economy several years out and inflation spikes can be devastating for people on fixed incomes. A traditional U.S. Treasury bill might offer a higher yield but no adjustment for inflation. So compared with regular Treasuries, TIPS were viewed as a worry-free investment.

Sounds like pretty good, right? Maybe too good. TIPS' virtues prompted economists like Zvi Bodie to suggest in 2009 that people should put 100 percent of their retirement savings into TIPS.

Of course, your mother taught you not to put all of your eggs in one basket. But this classic caveat didn't discourage the ensuing demand for TIPS by investors who went hog wild on them. The demand grew so great that the government no longer had to offer attractive yields (the fixed or non-inflation rate) to get people to buy them, and these rates went down.

Meanwhile, those planning to keep buying TIPS indefinitely probably weren't paying much attention to a significant wrinkle: that for TIPS to fully protect investors from inflation, the inflation-based rate paid by the government can't be lower than actual inflation. Some in the bond industry have long taken issue with the way the government calculates the inflation-based rate, saying that it has an incentive to low-ball this figure.