How TIPS are Used
TIPS are used for adding some inflation protection to the fixed income allocation of investment portfolios, or they can be purchased in a more tactical vein, on their own, in anticipation of increased inflation. The addition of TIPS to the fixed income investments of a balanced portfolio can help to lessen the volatility of those investments, just as fixed income securities help to lessen the volatility of the complete portfolio.
Of course, as payments increase with inflation they can also decrease with disinflation, or deflation. This makes nominal bonds (bonds not adjusted for inflation) much more attractive to investors, as their payments stay at a fixed amount during times of economic downturns.
An expected inflation rate can be determined for long terms by comparing a TIPS yield-to-maturity (YTM) with the yield of a similar, nominal US Treasury bond. For example:
A TIPS bond was purchased at an auction at a YTM of 2.5% with a 10 year maturity that is due on January 15, 2014.
A similar US Treasury bond was purchased at a YTM of 4.5% with a 10 year maturity that is due on the same day.
YTM (US Treasury) 4.5% - YTM (TIPS) 2.5% = real rate of return 2%
Subtracting the YTM of the TIPS from that of the US Treasury bond equals a real rate of return of 2% for the US Treasury bond. This is also considered the government's approximation of the expected inflation rate for these investments.
If an investor is expecting that the rate of inflation will increase to 3%, he would want to invest in TIPS as they will become more valuable in the future against market expectations. The opposite also holds true as the rate of inflation decreases which may cause an investor to sell, or wait for the price to be adjusted downward.